Mitigating Systemic Risk

A Role for Securities Regulators

Discussion Paper

TECHNICAL COMMITTEE

OF THE

INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS

OR01/11 FEBRUARY 2011

2

Contents

Chapter Page

Executive Summary 3

1 Systemic Risk within the Context of Securities Regulation 6

A. Introduction 6

B. The Traditional Approach to Securities Regulation 7

C. Lessons from the crisis for Securities Regulators 8

D. Post- Crisis Responses 10

2 Sources and Transmission of Systemic Risks 16

A. Sources of Systemic Risk in the Securities Markets 16

B. Development and Transmission of Systemic Risk

22

C. Systemic Risks and Securities Regulators‟ Oversight 26

3 Initial Considerations for Identifying Systemic Risk 30

A. What are Securities Regulators‟ Existing Approaches to Identifying

Risks and How Can They Contribute to the Identification of Systemic

Risk

30

B. Initial Considerations in Developing Systemic Risk Indicators for

Securities Regulators

33

4 Mitigating Systemic Risks and Promoting Financial Stability 39

A. Tools Available to Securities Regulators 39

B. IOSCO‟s Role 57

5 Conclusion 61

Appendix A: Possible Indicators Relevant to Systemic Risk 63

Appendix B: List of Members of the Working Group on Systemic Risk 68

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Executive Summary

This Discussion Paper of the Technical Committee (TC) of the International Organization of

Securities Commissions (IOSCO) addresses the role that securities regulators play in

promoting financial system stability. In particular, the paper provides insight and guidance

on the tools that can be used by securities regulators to identify, monitor, mitigate and

manage systemic risk.

Securities regulators have a key role to play in addressing systemic risk, bringing their

particular perspective as market integrity regulators. To this end, IOSCO has identified

reducing systemic risk as one of the three objectives of securities regulation. The recent

financial crisis has led securities regulators to put greater emphasis on systemic risk and

financial stability.

In July 2010, IOSCO adopted new principles of securities regulation including the need for

processes to monitor, mitigate and manage systemic risk and to review the extent of

regulatory coverage.1 IOSCO also created the Working Group on Systemic Risk (Working

Group) to examine the role of securities regulators with respect to systemic risk. This paper,

which is the core deliverable of that working group, aims to:

promote discussion of the ways in which systemic risk intersects with the mandate of

securities regulators; and

provide insight into how IOSCO and securities regulators should identify, monitor,

mitigate and manage systemic risk.

Promoting financial stability is a shared responsibility amongst the regulatory community.

Securities regulators, prudential regulators and central banks all have an important role to

play and come equipped with different tools at their disposal. The nature of the risk

identified will, to a large extent, dictate which set of tools will be most effective in addressing

the risk.

Due to their mandate and ongoing oversight, securities regulators have a number of

advantages in addressing certain aspects of specific systemic risk concerns. For example,

securities regulators, through their traditional focus on transparency and disclosure are well

placed to work towards an appropriate flow of information to market participants, investors

and regulators.

A key message of this paper is that securities regulators are determined to develop a more

robust framework of oversight and supervision that emphasizes:

greater transparency and disclosure throughout markets, regardless of the level of

regulation applied to them, and an expansion of the scope of supervision;

an approach to financial innovation that seeks to better understand the potential risks

associated with financial innovation and find the right balance between unrestrained

innovation and overregulation;

1 IOSCO Objectives and Principles of Securities Regulation, July 2010, available at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf.

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increased internal resources devoted to monitoring market developments and identifying

emerging risks; and

engaging with other regulators and supervisors (i.e. prudential regulators, central banks

and self-regulatory organizations), both nationally and internationally, to produce a more

robust and coordinated framework for promoting financial system stability.

This paper is intended to provide guidance rather than a set of requirements. Thus, a general

theme running throughout is that each IOSCO member will need to determine its own

response in relation to its mandate and domestic regulatory structure as well as the relative

size and characteristics of its securities market. Individual regulators will consequently need

to evaluate the scale of their response and the extent to which they can leverage, rather than

duplicate, the work of other members of the regulatory community.

IOSCO‟s members have a variety of regulatory models, including integrated regulators and

those that are sectorally focused. In addition, a number of countries have adopted a structure

in which research and oversight of systemic risk is co-ordinated in a particular body or forum.

As a result, this paper aims to identify the tools and information regulators should have

access to, regardless of their source.

The Discussion Paper starts by putting into context the role of securities regulators with

respect to systemic risk. There are a number of lessons that can be learned from the recent

financial crisis which help to define the securities regulators‟ role. There have been a number

of developments around the world that have been aimed at reinforcing the regulatory

infrastructure and its ability to address systemic risk concerns pro-actively. Building upon

that, IOSCO has an essential role to play in coordinating activity across regulators and

establishing best-practices for securities regulators.

The paper then describes in Chapter 2 some of the primary ways in which systemic risk can

develop in securities markets. It also stresses the importance for securities regulators of

considering the channels through which the effects of a systemic crisis can be transmitted

across the financial system and the real economy. Understanding both the development and

transmission of risk will undoubtedly facilitate the regulators‟ roles in developing approaches

to identify and effectively address emerging systemic risk.

In Chapter 3, the paper proposes some approaches and indicators that securities regulators

may use in seeking to identify sources of systemic risk. To a large extent, securities

regulators will be able to leverage work of other regulatory bodies in their efforts to identify

activities in securities markets that contribute to systemic risk. It will be important however

for securities regulators to identify or develop their own risk indicators through the use of

both qualitative information (through general market surveillance, review of products and

securities offerings and business conduct oversight) and quantitative data (micro and macro

level indicators).

Lastly the paper provides guidance on how securities regulators can act, both to reduce the

opportunity for systemic risk to arise and to reduce its impact. The tools securities regulators

could consider using include measures to increase transparency, business conduct rules,

organisational, prudential and governance requirements and emergency powers. In some

cases, regulators will have to collaborate with other regulators and raise risk awareness. The

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aim of these measures is to promote conditions under which market participants are better

able and incentivised to manage and appropriately price risk.

The fundamental objectives of this paper are to outline a general approach that should be

taken by regulators and spur further discussion on the role of securities regulators in

addressing systemic risk. Recognizing that discussions on this topic will be ongoing, IOSCO

will continue to facilitate the dialogue among securities regulators as well as with the broader

regulatory community and other stakeholders.

The Working Group was co-chaired by the Autorité des marchés financiers of Québec and

the Ontario Securities Commission.

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Chapter 1 Systemic Risk within the Context of Securities Regulation

This chapter sets out the role securities regulators should play in addressing systemic risk. It

discusses:

the lessons learned from the recent financial crisis regarding systemic risk;

the role of securities regulators with regard to systemic risk; and

IOSCO's role in supporting financial stability, including, importantly, its principles

relating to systemic risk.

A. Introduction

The crisis had a severe impact on the real economy and was a sobering event for investors

and financial regulators. The crisis has thrown into question many fundamental assumptions

about the existing regulatory approach.

For some securities regulators, these questions highlight the failure of a broadly shared

conceptual framework for securities regulation which warrants a rethink in light of the crisis.

Other securities regulators argue that these questions did not challenge the pre-crisis

framework while others argue that there was no broadly shared conceptual framework before

the crisis.

Despite these differences, the events of the crisis provided lessons for securities regulators

and highlighted that changes are needed in the practices of securities regulators to address

failings evident from those events.

A key element of this consensus is that securities regulators must understand their role and

contribution in addressing systemic risk (and promoting financial stability). Securities

regulators need to consider how the core functions of business conduct regulation and

ensuring transparent, fair and efficient markets can support, and in turn be supported by,

monitoring and mitigation of systemic risk within securities markets, and how the core tools

of securities regulators can be better applied to address systemic risk concerns.

In this regard, the thinking of securities regulators is in line with other post-crisis work.

Addressing risks to financial stability has been a key and unifying theme in the work of

international financial institutions, governments and domestic regulators across all sectors in

the three years since the crisis.

The intensity and speed with which systemic problems spread through the broader market,

and the duration of those problems, highlighted the need for increasing the scope and use of

traditional financial regulatory tools as well as the introduction of greater monitoring of so-

called macro-prudential factors – that is, variables that can result in systemic risk. As a

result, financial authorities are engaged in a major effort to improve their understanding of

systemic risk, strengthen their ability to detect it and devise tools to mitigate it. Much of this

work has been led by international institutions (such as the International Monetary Fund

(IMF), the Financial Stability Board (FSB) and the Bank of International Settlements (BIS))

and central banks, as well as prudential supervisors in the context of the Basel III framework.

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In April 2009, the G-20 leaders recommended that regulatory frameworks be reinforced with

a macro-prudential overlay that promotes a system-wide approach to financial regulation and

oversight and mitigates the build-up of systemic risk. They also called for all financial

authorities to take account of financial stability and develop effective tools to address

systemic risk.2 The FSB was established in April 2009 as a successor of the Financial

Stability Forum, with a mandate to address vulnerabilities and develop and implement

regulatory, supervisory and other policies in the interest of financial stability.

Leaders reiterated their commitment towards reducing systemic risk at the June 2010 Summit

in Toronto.3 The G-20 also commissioned work in various areas including the definition of

systemic risk, informational gaps and the regulation and oversight of systemically important

financial institutions (SIFIs).

In line with the international context and regulatory developments, this paper focuses on the

practical implications for securities regulators by identifying lessons from the crisis.

B. The Traditional Approach to Securities Regulation

B.1 The IOSCO Objectives and Principles of Securities Regulation

IOSCO‟s Objectives and Principles of Securities Regulation (Principles)4, drafted in 1998

after the Asian financial crisis and revised in 2003, set out a framework for the regulation of

securities markets, intermediaries in those markets, issuers of securities, and matters relating

to collective investment schemes. IOSCO expects these Principles to provide securities

regulators with high-level guidance for their work. They have developed into the key

international regulatory standards for the securities sector.

The Principles are supported by a comprehensive Methodology5, which the IMF and the

World Bank use to assess national securities regulation regimes via the Financial Sector

Assessment Program. The Methodology is intended to be used by the FSB for its peer

reviews.

The Principles positioned securities regulators as carrying the primary responsibility for

maintaining and enhancing the integrity, efficiency and fairness of securities markets, and for

protecting investors from improper behaviour by market insiders and others with

informational advantages. The Principles also made clear that securities regulators have a

fundamental role to play in maintaining confidence in the market and promoting

2 Enhancing Sound Regulation and Strengthening Transparency, G-20, March 2009, available at

http://www.g20.org/Documents/g20_wg1_010409.pdf.

3 “The recent financial volatility has strengthened our resolve to work together to complete financial

repair and reform. We need to build a more resilient financial system that serves the needs of our

economies, reduces moral hazard, limits the build-up of systemic risk and supports strong and stable

economic growth”. The G-20 Toronto Summit Declaration, G-20, 26-27 June 2010, available at

http://www.g20.org/Documents/g20_declaration_en.pdf.

4 Objectives and Principles of Securities Regulation, June 2010, available at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf.

5 Methodology for Assessing Implementation of the IOSCO Objectives and Principles of Securities

Regulation, February 2008, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD266.pdf.

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transparency.

The primary emphasis of the Principles is on comprehensive disclosure and market

discipline, backed by regulatory oversight, to protect investors and enhance confidence.

They also emphasised the role of business conduct regulation and corporate governance in

protecting investors and addressing any misalignment in the interests of managers and

investors.

The Principles recognised the importance of systemic risk and the role of securities regulators

in preventing and mitigating such risks.6 Nonetheless, one of the lessons of the crisis is that

securities regulators, among others, generally paid insufficient attention to systemic risk.

B.2 Insufficient focus on systemic risk

The pre-crisis practices of securities regulators and the Principles reflected a lack of a

financial stability perspective in securities regulation. In many cases, the focus of securities

regulation also reflected the architecture of financial and economic regulation.

With most monetary authorities targeting financial stability via money-market and credit-

market instruments, and with financial regulators focusing squarely on the soundness of

individual financial institutions and the integrity of financial markets, there was no generally

recognised need for securities regulators to take a financial stability perspective. There was

also limited research on the impact of financial market developments on the soundness of

financial institutions and the stability of the financial system. As a result, securities

regulators did not have a significant role in identifying and responding to macro-prudential

issues.

Of course, this did not preclude cooperation among agencies aimed at securing financial

stability. In some jurisdictions prudential regulators and monetary authorities shared

information and cooperated in stress-testing the banking system. However, the focus on

regulating individual institutions meant that there was limited inter-agency research and

coordination regarding the distribution of risks among these entities and the correlation of

risk profiles across the sectors.

C. Lessons from the Crisis for Securities Regulators

The crisis highlighted that although the traditional disclosure and business conduct oversight

functions of securities regulators contribute to a reduction of systemic risk, they are not

specifically designed to do so and, in their scope and application at the time of the crisis,

were not sufficient to prevent systemic risk from emerging and threatening financial stability,

particularly when those risks emerge in areas where disclosure and business conduct rules are

inapplicable, insufficient or inadequately applied. During the crisis, a number of contributing

factors that threatened financial stability were not sufficiently mitigated by the practice and/or

scope of business conduct oversight and disclosure regulation prevailing at the time.

The following are examples:

6 One of the three overarching objectives of securities regulation stated in the preamble to the original

Principles is the reduction of systemic risk, and Principle 30 was concerned with the reduction of

systemic risk.

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a) The role of non-bank financial institutions (with securities regulators as the primary

regulator). Some of these institutions played a similar role to banks in creating and

transmitting systemic risk, but were not subject to a corresponding level of

supervision;

b) The interconnectedness of the global market place. The growing interactions between

banking and capital markets and the level of interconnectedness in the system were

not properly understood and monitored by regulators or market participants, and

therefore risks that were magnified by interconnectedness were not appropriately

priced in the market;

c) Capital requirements and prudential standards which did not create incentives for

appropriate risk taking. Market participants may have had incentives to move their

activities to less regulated and more opaque segments of the system, negating the

effectiveness of existing regulation;

d) Product complexity. Complexity challenged the capacity of disclosure and market

conduct regulation to overcome information asymmetries and resolve conflicts of

interest: even with the disclosure available at the time, certain market participants,

including professional investors and market gatekeepers, lacked an understanding of

the risks inherent with complex investments;

e) Product innovation. Notwithstanding their benefits, innovations in finance

complicated institutions‟ risk management and increased the cost of information by

increasing interconnections between markets and amplifying problems in particular

markets and institutions of any size and function, resulting in transmission of risk

through other parts of the financial system. Inadequate disclosure about the risks

associated with new products exacerbated this problem, and a lack of understanding

of risks also contributed to the lack of disclosure;

f) Conflict management. Managing conflicts of interest, especially in financial

conglomerates became more difficult and costly. Certain gatekeepers – in particular

credit rating agencies – were not subject to sufficient (reputational) constraints and

there was over-reliance on their assessments of the risks attached to institutions,

products and strategies rather than internal risk assessments;

g) The cyclicality of financial markets, and the tendency for both regulation and market

participants‟ behaviour to be pro-cyclical; and

h) The risks in over-the-counter (OTC) markets. A lack of transparency and robust

infrastructures in OTC markets have undermined market confidence at the height of

the crisis, raising fears over counterparty strength and contributing to the rapid

evaporation of liquidity, thereby exacerbating the crisis.

Securities regulation did not adequately deal with these features and consequently the

following outcomes were observed:

a) Certain activities that had significant impact on incentives, the flow of information or

distribution of risks were not regulated in many jurisdictions (for instance credit

ratings agencies).

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b) Inadequate attention was given to the negative externalities and systemic implications

of risks accumulating as a result of individual institutions‟ behaviour (this goes to the

need for a macro-prudential framework highlighted by international institutions and

G-20 leaders);

c) Prior to the crisis, in many jurisdictions, securities regulators were not charged with

evaluating systemic risk as part of their official remit, which was typically focused on

investor protection and market integrity. In some cases, there was a misunderstanding

of the risks in the system and an inadequate and/or incomplete application of the

traditional tools of securities regulators to limit undesirable or improperly priced risk-

taking through market discipline, disclosure and corporate governance.

D. Post-crisis Responses

The work of international institutions and the regulatory community since the crisis has

focused primarily on addressing risks to financial stability. This section sets out those

responses and outlines the response of IOSCO and securities regulators.

D.1 Recent work at the international level

D.1.1 Defining and measuring systemic risk

In 2009, the IMF, the FSB and the BIS set out an approach to assessing systemic

importance.7 They first proposed defining a “systemic event” as “a risk of disruption to

financial services that (i) is caused by an impairment of all or parts of the financial system

and (ii) has the potential to have serious negative consequences for the real economy.”

They then outlined three main criteria to assess the “systemic importance” of firms, markets

or instruments. These were size (the volume of financial services provided by the individual

component of the financial system), substitutability (the extent to which other components of

the system can provide the same services in the event of a failure) and interconnectedness

(linkages with other components of the system). They proposed that an assessment based on

these three criteria should be complemented with reference to financial vulnerabilities

(leverage, liquidity risk, maturity mismatches and complexity) and the capacity of the

institutional framework (including market infrastructures) to deal with financial failures.

These guidelines offered an early conceptual framework which has since served as a very

useful reference point for supervisors and the industry alike. However, the practical

implementation of those guidelines remains challenging, in particular due to the nature of our

markets and instruments as well as the measurement and inclusion of criteria other than size.

These initial considerations have been augmented by various contributions offering sectoral

perspectives (e.g. insurance, hedge funds, money market funds), raising specific concerns

(e.g. in relation to high frequency trading or systemic aspects of the credit default swaps

markets)

or reflecting the industry‟s views (notably, the difference between systemic

importance and systemic risk and the benefits of large financial institutions). Different

7 Guidance to assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial

Considerations and Background paper, Report to G-20 Finance Ministers and Governors FSB, IMF,

BIS, October 2009, available at http://www.bis.org/publ/othp07.pdf.

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dimensions of systemic risk are being discussed, such as the impact of concentration,

contagion mechanisms and aspects of collective behaviour (herd effects, crowded trades and

market freezes), many of which are relevant to securities regulators. Alongside the potential

for a shock to the financial system and its propagation, the time dimension of systemic risk

emerges as an important element to consider and is connected to the work on the pro-

cyclicality of financial and regulatory behaviour. Those various contributions highlight the

complexity and diversity of risks to be considered.

This work is complemented by a vast effort by the IMF, the BIS, central banks, academics

and others to improve the identification of systemic risk sources and develop early warnings

(e.g. using stress indicators and risk maps). New methodologies are being tested to measure

individual contributions to systemic risk and improve the understanding of the various

contagion effects across the financial system (network approaches, co-risk and default

clustering models and portfolio approaches). In connection to this work, the FSB and the

IMF have published a map of information gaps in identifying sources of systemic risk (in

particular regarding the collection of information on linkages between financial institutions

and including information about unregulated areas of the financial system), alongside

recommendations for strengthening data collection.8 This area clearly remains a major

challenge for supervisors and the industry, in terms of coverage and types of data requested

(at the macro and financial institution level) for reporting, analysing and exchanging

information, and of costs involved.

D.1.2 The new prudential framework and the regulation and oversight of Systemically

Important Financial Institutions

The revision of the banking prudential framework was seen as a major step preventing the

accumulation of risks in the financial system. Measures include seeking to increase capital

(both the quantity and quality thereof) and better calibrate specific risks such as market risks

and the treatment of credit counterparty risk. Other changes aim to address risks related to

size, leverage or interconnectedness and to reduce pro-cyclicality and the build-up of

systemic risk (e.g. the proposals for countercyclical capital buffers). The new framework

also provides for the regulation of products and institutions that have been recognised as

having the potential to pose systemic risk. For example, the new framework provides

incentives to clear OTC derivatives through central counterparties (CCPs); these incentives

will support the important structural trend initiated since the crisis to reduce risks through

central clearing (cf. also CPSS-IOSCO‟s current work on the revision of standards for

CCPs)9.

The FSB is conducting additional work to address the risks of SIFIs, aimed at ensuring

greater loss absorbency by various means. A key challenge is to define those systemic

institutions and how to manage associated moral hazard issues. Partly to reduce the moral

hazard posed by SIFIs, supervisors and regulators around the world are working to strengthen

supervisory cooperation and improve crisis management and resolution tools, notably at the

international level.

8 The Financial Crisis and Information Gaps, FSB/IMF, October 2009, available at

http://www.financialstabilityboard.org/publications/r_091107e.pdf. See also Systemic Risk Information

Study, SIFMA, June 2010, available at

http://www.sifma.org/regulatory/pdf/SIFMA_Systemic_Risk_Information_Study_June_2010.pdf.

9 Press Release CPSS - IOSCO review of standards for payment, clearing and settlement systems 2

February 2010, available at http://www.iosco.org/news/pdf/IOSCONEWS177.pdf.

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D.1.3 Institutional arrangements to support effective macro-prudential oversight

Specific new institutional arrangements have been approved to strengthen system-wide

oversight and help meet some of the challenges identified during the financial crisis.

Examples include the establishment of the Financial Stability Oversight Council (FSOC) in

the United States of America and the setting up of the European Systemic Risk Board

(ESRB). They will be in charge of identifying systemic risk, preventing regulatory loopholes

and the emergence of risks outside the regulated sector, and making recommendations. Both

the FSOC and the ESRB will have devoted resources and access to significant research

efforts. Several countries have also established systemic risk committees, such as the United

Kingdom, France, Germany, Spain, Hong Kong and Brazil and we expect others to follow.

Securities regulators are members of those bodies.10

The aim of both existing and new institutional frameworks is to help coordinate micro-

prudential and macro-prudential approaches and facilitate cooperation among supervisors.

Data collection efforts being undertaken will feed the work of these various systemic risk

bodies, which will also have to consider international linkages as well as cross-border

activities and markets.

Securities regulators‟ participation in the discussions has so far been limited, partly because

the risks relating to markets as opposed to institutions are perhaps more diffuse and difficult

to tackle, and partly because securities regulators have not been at the forefront of

considering financial stability issues. However, many of the reforms pursued by securities

regulators since the financial crisis contribute to financial stability by targeting specific

vulnerabilities and potential sources of systemic risk. They mark a significant sharpening of

focus of the securities regulators, and of IOSCO, on systemic risk.

D.2 A Revised Approach to Securities Regulation

D.2.1 Revised IOSCO Principles

After the financial crisis, IOSCO revised the Principles to provide guidance on how issues

highlighted by the crisis should be addressed. The revisions included eight new Principles as

well as several revisions to existing Principles, and these have been noted by the FSB and the

G-20.

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For instance at the European level, ESMA (the newly-established European Securities Markets

Authority) is a contributor to the ESRB general oversight, alongside domestic regulators. In the United

States, market regulators such as the CFTC and the SEC contribute to the assessment of risk by the

FSOC, along with prudential regulators and the US Treasury. In Brazil, the Ministry of Finance

formed in 2006 a committee (the “Supervisory and Regulatory Committee of Financial Systems,

Capital Markets, Private Insurance and Social Welfare” or “COREMEC”) to coordinate and to improve

the performance of the federal agencies that govern and control the activities related to the financial

system. The COREMEC created recently a Steering Committee that should report the developments of

market participants that pose risks to the financial system and indicate the needs of a joint and

coordinated action of the four regulators in order to assure the financial stability. Some other

jurisdictions already had formal or informal institutional arrangements in place that allowed the

regulators, central banks and policy makers to monitor risks across two or more sectors in the financial

system. For example, Australia‟s Council of Financial Regulators performed this role prior to and

during the crisis, and continues to do so.

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In particular, IOSCO adopted two new principles on identifying, assessing and mitigating

systemic risk (Principle 6), and on reviewing the regulatory perimeter (Principle 7), and is

currently in the process of developing an appropriate methodology to support these new

principles. The preparation of this Discussion Paper is intended to contribute to that work.

These principles are among eight relating to the conduct of securities regulators, and both

relate to the third objective of securities regulation, which is to reduce systemic risk.11

In

addition, IOSCO also decided to incorporate identification and mitigation of systemic risk in

the organisation‟s strategic mission and goals for the next five years.

Principle 6 and the associated commentary approved by IOSCO are as follows:

The Regulator should have or contribute to a process to monitor, mitigate and manage

systemic risk, appropriate to its mandate.

Systemic risk refers to the potential of any widespread adverse effect on the financial system

and thereby on the wider economy. Factors which can give rise to systemic risk may include

the design, distribution or behaviour under stressed conditions of certain investment products;

the activities or failure of a regulated entity; a market disruption; or an impairment of a

market's integrity. Systemic risk can also take the form of a more gradual erosion of market

trust caused by inadequate investor protection standards, lax enforcement, insufficient

disclosure requirements, inadequate resolution regimes or other factors.

The regulator should have or contribute to regulatory processes, which may be cross-sectoral,

to monitor, mitigate and appropriately manage such risk. The process can vary with the

complexity of the market. Regulators should have particular regard to investor protection,

market integrity, and the proper conduct of business within markets as contributing factors to

reducing systemic risk.

Principle 7 and the associated commentary approved by IOSCO are as follows:

The Regulator should have or contribute to a process to review the perimeter of regulation

regularly.

The Regulator should adopt or participate in a process for conducting a rigorous and regular

review of markets and market participants‟ activities so as to identify and assess possible

risks to investor protection, market fairness, efficiency, and transparency or risks to the

financial system and review the existing perimeter of regulation in order to mitigate risks to

these regulatory Objectives. Such review should include consideration of whether new

developments in financial products have an effect on the scope of securities regulation, and

whether the regulatory premises underlying any existing regulatory exemptions (such as

those dealing with sophisticated or institutional investors) continue to be valid. Regulators

should have in place a process for both periodically and on an ad hoc basis determining

whether the regulators‟ existing powers, operational structure, and regulations are sufficient

to meet potential emerging risks.

Such a process should allow for any necessary changes to the existing perimeter of

regulation, which may also include seeking legislative amendment, to be made effectively

and in a timely way in response to an identified emerging risk.

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Supra footnote 4.

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D.2.2 IOSCO’s role in monitoring and mitigating systemic risk

In addition to the application of the new Principles concerning systemic risk, IOSCO can

support the development of a systemic risk perspective in securities regulation through other

activities. The initiatives and proposed activities draw on IOSCO‟s strengths in developing

international standards and regulatory responses to issues in securities regulation and

promoting cooperation.

IOSCO‟s policy and guidance-setting activities allow IOSCO to lead responses to emerging

regulatory issues – including those that may increase systemic risk. Examples are the Task

Forces and Standing Committees that addressed issues arising from of the financial crisis (see

Figure D at the end of the paper).

IOSCO is undertaking close collaboration and consultation with industry participants and

senior supervisors for purposes of intelligence gathering and discussions about systemic risk.

Importantly, IOSCO is also building its research capability to provide cross-jurisdictional

analyses of securities markets.

These activities can all strengthen IOSCO‟s ability to influence international debate on

emerging risks and mitigation tools. These opportunities and examples of IOSCO work are

discussed in Chapter 4 Section B of this paper.

D.2.3 Issues for Securities Regulators

Securities regulators have begun to focus on systemic risk in line with revisions to the

Principles, and the activities outlined above. They recognise that the pre-crisis practices that

emphasised market discipline and transparency remain essential but need to be strengthened

and complemented by stability focus on the challenges presented by systemic risk.

This focus will require changes in the approach to securities regulation and will require

enhanced access to information for regulators (e.g. through trade repositories) and better

surveillance systems that are able to cope with the greater integration of markets and

technological developments. It will also require a significant increase in supervisory

resources and enhancements in securities regulators‟ capabilities for risk analysis. The

resulting increase in costs for market participants and regulators will need to be balanced with

the benefits of more intensive oversight. Lastly, it will also require regulators together with

the responsible body (in some jurisdictions, the central bank or the systemic risk oversight

body) to mitigate any emerging systemic risk before they can crystallise and threaten the

financial system, as well as to reduce the impacts of any risks which, for whatever reason,

happen to materialize.

All such actions are consistent with and support securities regulators‟ current mandates

regarding market efficiency and integrity, corporate governance and investor protection.

The new direction implies not only monitoring the emergence of potential risks in the system,

but also ensuring that financial markets are working efficiently and contributing positively to

the real economy (financing, hedging and transfer of risks, price formation, and access to

liquidity and efficient allocation of savings).

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This Discussion Paper will highlight the issues securities regulators should consider in

addressing systemic risk. Chapter 2 outlines the sources of systemic risk. Chapter 3 sets out

how systemic risk can be identified while Chapter 4 discusses the measures securities

regulators can take to address systemic risk.

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Chapter 2 Sources and Transmission of Systemic Risks

This chapter describes the sources of systemic risk, how systemic risk develops, how it is

transmitted through the securities markets and the implications for securities regulators. It is

intended to provide the theoretical basis for the discussions in Chapters 3 and 4 relating to the

identification and mitigation of systemic risk. Figure A describes the experiences of

emerging markets during the financial crisis.

A. Sources of Systemic Risk in the Securities Markets

A number of sources of systemic risk have been identified by regulators and academic

researchers. In this paper we have focused on sources which fall within the jurisdiction of

securities regulators. The sources discussed below may serve as determining factors when

assessing whether a particular market element (i.e. a market participant, market, market

infrastructure or market activity) poses potential systemic risk. Systemic risk can build up

because of a single factor, but may very well develop through a combination of the factors

listed below.

It is commonly accepted that size, interconnectedness and substitutability constitute the core

factors to consider when assessing the potential for systemic risk12

. In addition, there are a

number of other factors that can contribute to systemic risk but in isolation do not pose a

concern. The discussion below describes the factors in more detail. However, the list of

factors is not exhaustive.

A.1 Size

Size is often considered the most important factor when assessing the potential for systemic

risk. Conceptually, the larger the market element being considered, the more damage its

failure can potentially cause to the market. Although systemic risk has traditionally been

considered in relation to the banking sector, the growth of the non-bank sector has

highlighted that the size of financial institutions rather than bank status has become more

systemically important.13

Size has mostly been used to identify banks deemed “too-big-to-fail”, but is also relevant

when considering a combination of many small firms14

. . In that case, significant size may be

reached if, for instance, such firms have adopted similar investment strategies. Size is also

relevant when analyzing financial activities or practices, exposures to other market

participants, individual transactions and trading volumes. In addition, the use of leverage

allows smaller market participants to have a disproportionate impact on the market and

increases their potential to pose systemic risk (see below for more discussion under

Leverage).

12

FSB, IMF & BIS, supra note 7 at 11.

13 Schwarcz, Steven L. Systemic Risk, Duke Law School Legal Studies Paper No. 163; Georgetown Law

Journal, Vol. 97, 2008, 193-250, available at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1008326.

14 An example of systemic implications is the U.S. savings and loan crisis of the 1980s in which about

750 “thrifts” became insolvent, requiring a government bailout of $160 billion, or an average of about

$213 million per institution. See for example, Nouriel Roubini and Stephen Mihm, Crisis Economics:

A Crash Course in the Future of Finance.

17

Size may be a determining factor when considering markets as well. Once they attain a

certain volume, markets in of themselves can pose risks, since they often serve as important

pools of liquidity.

Size will also matter when considering investment products, particularly those with a high

degree of complexity, a lack of transparency and/or an undesirable selling practice.

Using absolute size as the only proxy for systemic importance may however leave some

sources of systemic risk undetected. “Legislative proposals that rely on a size-based

identification process would erroneously identify a number of financial firms as systemically

risky, when in fact they are not. Other firms that do in fact pose significant systemic risk

would fail to be identified.”15

While size is an important consideration when assessing systemic risk, it should not be

considered in isolation from other variables. In terms of entities, activities or markets, size

alone does not necessarily imply systemic risk.

A.2 Interconnectedness

The interconnectedness of institutions or markets has been identified as a key consideration

in assessing systemic risk. Regulators must therefore not only look at firms at the

institutional level, but also from an industry perspective. Linkages or interconnections have

increased due to a number of factors, such as globalization (including the growth of global

financial institutions), financial innovations (such as derivatives, securitization and wholesale

funding), business strategies, technology and product characteristics. In addition,

communication technologies have accelerated the speed with which information travels

between institutions and markets and therefore the speed with which the effect of

interconnections are felt.16

These developments have led to the introduction of the concept of “too interconnected to

fail”17

and to the development of different approaches to assess these linkages, which can be

highly complex and challenging to analyse.18

Hence, a firm that may not appear large

enough to reach systemic importance, but that is highly connected to others could become

systemically important. The potential for systemic risk can be heightened if the participants

are interconnected and one is dependent on the other. Greater transparency about

interconnections can help regulators and market participants to understand how systemic risk

may spread. This can facilitate preventative steps to address the spread of adverse effects.

15

Laursen, Christopher; Sharon, Brown-Hruska; Mackay, Robert, Bovenzi, John, Why ‘Too Big to Fail’

is Too Short-Sighted to Succeed: Problems with Reliance on Firm Size for Systemic Risk

Determination. New York: NERA Economic Consulting, 2010, available at

http://www.nera.com/67_5566.htm.

16 Schwarcz, Steven L. and Anabtawi, Iman, Regulating Systemic Risk. UCLA School of Law, Law-Econ

Research Paper No. 10-11, 2010, available at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1670017.

17 For example in the private securitization, derivatives and triparty repo market - United States –

Selected Issues, International Monetary Fund, 2009, available at

http://www.imf.org/external/pubs/ft/scr/2009/cr09229.pdf.

18 See Global Financial Stability Report, IMF, April 2009: including the network approach and the co-

risk model, available at http://www.imf.org/external/pubs/ft/gfsr/2009/01/pdf/text.pdf.

18

Interconnectedness can be found between banks, but also between other market participants

(e.g. insurers, broker/dealers, custodians, and hedge funds), clearing and settlement systems

or markets. When acting or making decisions, market participants typically do not take into

account the broader impact on others (referred to as externalities). These spillover effects can

potentially increase the fragility of the financial system.19

For example, when setting its

capital levels, a market participant will not take into account the contribution it makes to

reducing the likelihood of cascading bankruptcies and financial market instability.

The connections between market participants result not only from direct effects such as credit

or counterparty exposure but also through indirect effects or information channels which are

more difficult to identify and predict.

A.3 Lack of Substitutes and Concentration

Concentration risk can arise when only one or a few market participants provide a product or

activity. The potential impact is heightened when there are no effective or potential

substitutes. For example, market infrastructure entities that provide key services, such as

clearing and settlement systems, typically lack substitutes and therefore necessarily carry

concentration risk.

Similarly, markets can also harbor concentration risk when they serve as the preferred

platform for trading or raising funds. The risk is exacerbated if such markets provide vital

funding liquidity to the financial system, serve as the sole avenue of hedging significant risks

or provide an important price discovery function. For example, the repo market became a

core short-term funding source widely used by many market participants.20

Therefore,

impairment of this important market would have serious negative consequences on its users.

In addition, concentration risk can be found when a small number of market participants

control the trading in a particular market. This concentration of liquidity makes the market

dependent on the continued support of the participants. For example, Lehman Brothers was a

significant provider of liquidity in the CDS market. Lehman Brother‟s failure caused

considerable uncertainty regarding the exposure of other participants and the impact on their

balance sheets. A major effort by market participants was required to net out their respective

exposure to Lehman and rebalance their books through the replacement of trades.21

The elimination of some players following a crisis and the on-going market pressures for

consolidation in the financial sector can lead to a decrease in the number of institutions and,

as a consequence, the concentration of a significant percentage of activity in the hands of a

few.

The concentration of particular risks in the hands of one or a few market participants, who

may not be able to manage or offset these risks, can also be the source of a systemic event.

19

Schwarcz and Anabtawi, supra note 13.

20 Fontaine, Jean-Sébastien, Jack Selody and Carolyn Wilkins. Improving the Resilience of Core Funding

Markets. Bank of Canada Financial System Review, December 2009, available at

http://bankofcanada.ca/en/fsr/2009/fsr_1209.pdf.

21 Three Market Implications of the Lehman Bankruptcy, p. 6-7 BIS Quarterly Review, December 2008,

available at http://www.bis.org/publ/qtrpdf/r_qt0812x.htm.

19

While AIG presented a unique situation that may not be representative, it is an interesting

example given the company‟s role as a significant provider of credit default protection on

U.S. residential mortgage backed securities. When it became widely known that AIG was

experiencing financial difficulties and had written a substantial amount of CDS contracts,

confidence in counterparty performance significantly declined. This left many participants

unwilling to transact causing liquidity in that market to dry up.

Individual market participants can house concentration risks through the positions taken and

exposures to counterparties or markets. The risks to the system will be compounded if the

participant‟s size is large.

A.4 Lack of Transparency

Market participants need complete and accurate information about markets or products to

assess the potential return and exposure to risk. A lack of transparency about product

characteristics or market conditions can cause, for example, uncertainty about asset prices.

As the assessment of value is directly related to the risk associated with a product, market

participants require transparency. A lack of transparency regarding a product can result in

the inability to properly evaluate the risks and create sub-optimal price assessment. The

under-appreciation and, therefore, mispricing of risk can, in turn, lead to the creation of an

asset bubble or the widespread distribution of complex assets to participants less able to

appreciate their risk.

The combination of lack of transparency and product complexity is of great concern to

securities regulators. Complexity “creates an inherent information asymmetry between the

originator of a financial instrument and the investors who purchase it”.22

Simply providing

more information is not the same thing as providing transparency23

. The difficulty in

understanding the underlying assets of structured investments (such as a CDO-squared)

creates a lack of transparency that makes it even harder to mark-to-market.

Market transparency contributes to an effective price formation process and can promote

liquidity. Exchange-traded securities and derivatives provide transparency in terms of

standardized products, price discovery and publicizing trades, while OTC securities and

derivatives markets are more opaque. Lack of transparency negatively affects the ability of

market participants to properly price positions and value the associated risk. It also affects

the ability of regulators to identify the build-up of risk in the system. The Technical

Committee‟s Task Force on Commodity Futures Markets (Commodity Task Force) has noted

that information regarding the positions of large traders can assist regulators in this regard.

The lack of transparency is not only a matter of concern for market participants but also for

regulators. Regulators require a deep knowledge of the matters they oversee in order to

create a regulatory environment that fosters efficient capital markets while protecting the

investors. Knowledge gaps are more likely to result in regulatory inaction or cause regulation

22

Schwarcz and Anabtawi, supra, note 13.

23 “But an investor in a CDO-squared would need to read in excess of 1 billion pages to understand fully

the ingredients”, Rethinking the financial network, speech by Andrew G. Haldane, Executive Director,

Financial Stability of the Bank of England, p. 17, April 2009, available at

http://www.bankofengland.co.uk/publications/speeches/2009/speech386.pdf.

20

based on imprecise assumptions.

Transparency is crucial but is not always in and of itself sufficient to limit the development of

risks. For example, transparency alone will not ensure that incentives are appropriately

aligned. From the regulators‟ perspective, access to information is not enough. Regulators

must also use that information and act, as necessary.

A.5 Leverage

Leverage is a key source of systemic risk as it serves as an amplifier. A non-systemic risk

can become systemic through the simple effect of leverage. Leveraging can occur directly

using borrowed funds or indirectly via derivatives or other products that have embedded

leverage. Embedded leverage also intensifies pro-cyclicality in the financial system.24

In the context of a lending transaction, there must be a participant willing to take on leverage

risk and another willing to lend the funds. Leverage can also be achieved through financial

market transactions (e.g. derivatives contracts) which require a counterparty to take the other

side of the trade. The increased risk taken by the market participant in a leveraged position

creates risk for the lender or counterparty, although those counterparty risks can be lessened

in a number of ways, including through the posting of collateral. Furthermore, to assess the

leverage of an institution, one needs to take into account both sides of the balance sheet.

Overall leverage should be determined by considering not only the liabilities but also the

leverage embedded in assets (for example, leverage within structured products).

As mentioned earlier, leverage can make a smaller firm, or a collection of small firms, a

significant player in an asset class and a potential systemic risk.

The excessive leverage that had been taken on prior to the global financial crisis has led

market participants to deleverage balance sheets and investment portfolios. That

deleveraging furthered the downward price spirals experienced in the global financial crisis

as many participants simultaneously sold assets.

A.6 Market Participant Behaviour

The behaviour of participants can result in mispricing of assets and an accumulation of risk in

the financial system. For example, participants can be influenced by macroeconomic factors,

such as a prolonged period of low nominal interest rates and unusually low risk premiums.

This can eventually lead to excessive leverage and risk taking.25

“During extended periods of

prosperity, market participants become complacent about the risk of loss – either through

systematic under-estimation of those risks because of recent history, or a decline in their risk

aversion due to increasing wealth or both.”26

24

Redesigning the Contours of the Future Financial System, Kodres, Laura and Aditya Narain,

International Monetary Fund Staff Position Note, August 2010, available at

http://www.imf.org/external/pubs/ft/spn/2010/spn1010.pdf.

25 See Global Financial Stability Report, Chapter 2, International Monetary Fund, April 2010, available

at http://www.imf.org/external/pubs/ft/gfsr/2010/01/index.htm.

26 Systemic Risk, and the Financial Crisis of 2007-2008: Written Testimony for the House Oversight

Committee Hearing on Hedge Funds, Lo, Andrew W., Hedge Funds, 2008, available at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1301217.

21

Herding happens when individuals or firms simultaneously act in a similar manner. Herding

can come from many different sources27

and can be associated first with the build-up of asset

bubbles and later with irrational panic causing a market gridlock or a rapid decline of prices

in one or multiple markets (for example, because of a decrease in risk appetite).28

Today‟s

environment of increasingly rapid communications can also contribute to the development of

herding behaviour. In jurisdictions or markets without a system to collect information on

trading activity and/or positions, it can be challenging to identify herding.

A.7 Information Asymmetry and Moral Hazard

As the efficient functioning of financial markets is heavily dependent on the flow of

information, such markets are unavoidably affected by information asymmetry issues.

Participants can be challenged in their ability to assess the quality of financial products and

intermediary advice. Participants also face challenges in their ability to evaluate the

soundness of those with whom they transact (e.g. evaluating counterparty risk).

The interests of investors and their intermediaries may become misaligned as a result of the

intermediaries‟ compensation structure or focus on short-term profits. Misaligned incentives

can encourage intermediaries to take advantage of information asymmetries and put their

interests ahead of their clients‟. This can result in mispriced risk or inappropriate product

selection which, if widespread, can become a source of systemic risk.

Information asymmetry can also give rise to moral hazard issues. These can occur when

market participants have differing levels of information and one participant is insulated, in

some way, from the consequences of its actions. Concerns can arise when participants are

not accountable for their actions which can lead them to change their behaviour by taking on

higher levels of risk. For example, intermediaries may fail to undertake proper due diligence

if the consequences of doing so are not significant.

Moral hazard can also distort incentives for financial institutions. Large institutions with

implicit or explicit government guarantees (e.g. those that are “too-big-to-fail”) benefit from

a lower cost of capital. Those that lend to such institutions assume there is very low

probability of not getting their money back and so demand a lower return than would

otherwise be the case. This discounted cost of capital allows financial institutions to borrow

too cheaply and encourages them to take on higher levels of risk.

The concepts of moral hazard and information asymmetry have been used to explain some of

the shortcomings of the securitization market,29

credit ratings,30

and intermediary distribution

practices.

27

For example using the same risk model, following the same indices or similar investment strategies,

using the same trading algorithm or trading strategies as well as momentum investing.

28 Risk appetite, a component of global market conditions, could affect the probability of a systemic

episode. See IMF, Global Financial Stability Report, Chapter 3, 2009, supra note 18.

29 Adverse selection in the loan origination process and the role of rating agencies as providers of credit

ratings and providers of advice regarding product structures.

30 For example, the issuer-pay model results in the potential for conflicts of interest.

22

B. Development and Transmission of Systemic Risk

While risk can build up in different parts of the system and in different forms, for systemic

risk to crystallize there needs to be a triggering event which results in the spread of negative

consequences across entities and markets and eventually to the real economy. In reality, the

catalyst is usually a chain or combination of events. This section describes the types of

events that can lead to a systemic crisis and the channels through which risk can spread.

Trigger events may be sudden and unpredictable. It is therefore important for securities

regulators to focus on the sources of systemic risk and how that risk is transmitted. In this

way, it may be possible to limit the impact of an event. Even though trigger events are

difficult to predict, understanding the form an event can take may prevent its occurrence or

limit the impact.

B.1 Trigger Events

The trigger for a systemic event can be widespread, affecting multiple participants or

components of the financial system all at the same time. It is also possible that the trigger

can be a micro-level event affecting one or more participants or components that results in a

chain-like reaction. The trigger can also take the form of a combination of both macro and

micro events.

Trigger events can be significant in and of themselves (e.g. stock market crashes) or can seem

relatively minor (e.g. concern about the solvency of a market participant) but have snowball-

like effects. As a result of the triggering event, market participants re-evaluate their exposure

to risk and make corresponding adjustments to portfolio holding and business operations.

B.1.1 Macro Events

When people think of a systemic event, they most often think of a shock that affects all or

most of the financial system at the same time. This kind of macro shock is generally a single

event that affects multiple parts of the system contemporaneously. Shared exposure across

participants can lead to near simultaneous losses that may then threaten the solvency of

multiple market participants.

Exogenous macro events (i.e. those originating outside of the financial system) can take

many forms. This type of event may be more commonly associated with a currency crisis,

such as the currency crises in Russia and Brazil in 1998. However, other macro-economic

type issues such as the OPEC oil crises, a slump in residential house prices or even a

significant crop failure can also affect a large number of market participants at the same time.

These types of events can link back to securities markets in numerous ways such as direct

holdings or derivatives.

Events originating in securities markets can also be a systemic risk concern. For example, a

collapse in market valuations or the seizure of a market can lead to widespread and

simultaneous impacts on those that participate in those markets.

B.1.2 Micro Events

Systemic risk can also be a concern even if the trigger event starts with a limited number of

23

firms or markets. Through direct and indirect interconnections, such an event can spread to

other parts of the securities markets and ultimately to the real economy. For example, the

failure of one institution can directly affect another starting a chain reaction across one or

more institutions and markets. This can ultimately have material adverse effects on the

securities markets and broader economic activity.

B.2 Risk Transmission

Another key element of systemic risk is the channel through which the negative

consequences of a triggering event can be transmitted between multiple firms and/or markets.

If the transmission is broad enough, the event can threaten financial stability and real

economic activity. This was seen in the financial crisis, with securitization transmitting

failure in mortgage underwriting practices to financial markets.

Financial markets exist, in part, to transfer risk from one participant to another. As such, the

effects of changes in market conditions are transmitted naturally as part of the markets‟

adjustment to new information and that transmission is essential to its efficient functioning.

However, in times of stress, these channels can also lead to the spread of systemic risk.

Risk can propagate from one firm or market to another and from the greater financial system

to the broader economy through two primary channels. The first is direct financial exposure

between entities. Losses or, at the extreme, insolvency, at one firm have a direct impact on

those with whom the firm has financial obligations.

The second manner of transmission is through information effects. Securities markets rely

heavily on information and are susceptible to changes in perceived levels of risk. This

channel of risk transmission can be just as devastating as direct financial exposure but can be

more challenging for regulators to understand and address.

We have identified five primary ways by which risk can be transmitted through financial or

information channels or a combination of both.

B.2.1 Counterparty Exposure

The financial system is often described as a network of interconnected balance sheets.

Similarly, securities markets are networks of interconnected trading books and portfolios.

Market participants are often linked by trading relationships between one another (e.g.

derivative contracts) or membership in central counterparties.

Market intermediaries often trade between one another, with inter-dealer markets being as

important to securities markets as inter-bank lending is to the banking sector. These

interconnections create a counterparty or credit risk channel for the transmission of risk.

B.2.2 Changes in Liquidity

Liquidity is, in effect, the lifeblood of the financial system. It allows participants to enter or

exit positions efficiently without undue impact on the price of a security. Liquid markets can

also be an important source of funding and capital for market participants. The rapid

evaporation of liquidity can affect the ability of a firm to meet its financial obligations and

can be a channel through which the negative effects of a trigger event can spread across

24

securities markets and throughout the financial system.

In recent years, securities markets have grown in importance as a source of funding for firms.

31 This trend has meant that firms are susceptible to changes in liquidity conditions.

Reduced liquidity in certain markets can be a particular concern for firms that rely on short-

term liabilities to fund longer-term assets. During the financial crisis, this was a particular

concern for commercial paper markets, including asset-backed commercial paper.

For example, Lehman Brothers was a large issuer of commercial paper. When it declared

bankruptcy, its paper, which was widely held by money-market funds, became effectively

worthless. This caused significant losses for money-market funds, most notably for the

Reserve Primary Fund. Growing concern about the solvency of commercial paper issuers

lead market participants to reduce their risk exposure by withdrawing from the market. As a

result, the amount of financial commercial paper outstanding fell 30% in the six weeks

following Lehman‟s bankruptcy.32

An increase in uncertainty regarding market conditions can quickly lead to the withdrawal of

participants from a market. For example, a lack of transparency regarding the financial

exposure or solvency of potential counterparties may cause liquidity to dry up, as participants

decide to reduce their participation in and exposure to the market. In addition, large price

declines could cause a further deterioration of available liquidity as participants may be less

willing to transact in a falling market.

Reduced liquidity can result in fire-sale type scenarios for those forced to exit a position in an

illiquid market. It can also cause firms to have to sell other assets in other markets. This can

then cause the illiquidity in one market to impact asset values in another. 33

On May 6, 2010, U.S. securities markets experienced a short period of extreme market

volatility (the so-called flash crash), with the prices of a number of securities falling

dramatically in a matter of minutes. The extreme movement in prices left many participants

with uncertainty as to the true market conditions. The result was that many market

participants withdrew from the market causing a reduction in market liquidity. Once the

market stabilized, they were able to assess true market conditions and resumed trading

activities, causing prices to recover within a short period of time.34

31

Global Financial Stability Report, Chapter 2, International Monetary Fund, October 2010, supra note

18.

32 When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009, Kacperczyk,

Marcian and Philipp Schnabl, Journal of Economic Perspectives, Winter 2010, available at

http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_schnabl_nov09.pdf.

33 Market Liquidity and Funding Liquidity, Brunnermeier, Markus K. and Pedersen, Lasse Heje, Review

of Financial Studies 22 (6), 2201-2238, June 2009, available at

http://www.princeton.edu/~markus/research/papers/liquidity.pdf.

34 SEC-CFTC Joint Report Regarding the Market Events of May 6

th, published 1 October 2010. See

http://www.cftc.gov/ucm/groups/public/@otherif/documents/ifdocs/staff-findings050610.pdf.

25

B.2.3 Feedback Loops

A process is said to be “tightly coupled”35

if it moves from one stage to another with little

opportunity for intervention. In financial markets, this can occur when trades are based on

price changes, which then cause a further change in an asset‟s price. In this way, the change

in asset prices becomes self-feeding. For example, ratings downgrades, especially those to

below investment grade, can force investors to liquidate positions, placing downward

pressure on asset prices.

Tight coupling can occur when automated processes are used in trading. Trading algorithms

can create feedback loops when they respond to changes in the price of a security that were

initiated by the algorithm or another trader.

Risk can also be transmitted in this manner when there are contractual requirements to

respond to price changes (e.g. debt covenants). For example, if a firm with a highly

leveraged position experiences a decline in the value of that position, it may face collateral

calls that require the sale of assets. Those sales further depress prices and collateral levels,

leading to further asset sales. The firm may find itself having to sell portfolio holdings it

wants to retain rather than those it wants to sell. This can then depress the price of the second

security and potentially lead to a downward spiral across assets affecting a large number of

investors. Through this kind of process, stable markets can be impacted by the price declines

and instability in other markets.

B.2.4 Correlation

Correlation is the tendency of the prices of different assets to move together or be similarly

affected by an event or the release of new information. Correlated assets can transmit risk

from one part of the system to another through changes in asset prices.

When investors have similar portfolio holdings or employ similar strategies, sharp changes in

the price of a particular asset can lead multiple market participants to make similar portfolio

decisions. Individually, these decisions by themselves would not pose a systemic risk.

However, when considered collectively, these potentially rational decisions can have a

significant impact on asset prices and market liquidity.

The correlation between different assets prices and its potentially amplifying effect can lead

to systemic risk concerns if it is not fully understood by market participants or if it changes

over time. Changes in correlation can be dramatic during times of financial stress. When

correlations change, market participants become less able to predict how the price of one

asset may respond to other changes.

Investment and risk management strategies can be based on the correlation between assets.

Participants may, therefore, experience significant losses when the assumed correlations

change. For example, investors may have purchased U.S. residential mortgage backed

securities assuming that if the mortgages were diversified in terms of geography, then the

default risks would be uncorrelated. However, significant and widespread declines in house

35

The tight coupling concept was first referred to by Richard Bookstaber in his article The Myth of Non-

Correlation in the September 2007 issue of Institutional Investor, also available at

http://rick.bookstaber.com/2007/09/myth-of-noncorrelation.html.

26

prices created a situation in which the defaults turned out to be highly correlated.

B.2.5 Loss of Confidence

While it is more common to think of risk being propagated through direct financial links

between participants, systemic risk can also be propagated through information effects that

do not involve obvious interconnections and direct causal links.36

Losses in one firm or market can cause uncertainty about other firms or markets. Such

heightened concern results in changes to the behaviour of other market participants. They

will seek to reduce their own risk by avoiding certain counterparties, markets or products.

The perceived riskiness of one market or participant spills over to others causing a broader

impact. Market based systemic events are often associated with a large number of

participants deciding to reduce risk taking.37

A lack of information and the inability to

distinguish risky from stable counterparties, markets or products can cause a loss of

confidence in one or more parts of the securities market.

C. Systemic Risks and Securities Regulators’ Oversight

It must be recognized that securities regulators have traditionally not exercised oversight

over, nor regulated, all types of activities conducted within the securities market. For

example, credit rating agencies, which have been an integral part of securities markets for

many years, have only recently been subjected to regulation in some jurisdictions.

Yet, securities regulators may be confronted with systemic risk originating both within and

outside the securities market. Securities regulators must also be mindful of regulatory gaps

that either exist or develop over time. In addition, regulators need to be increasingly sensitive

to the unintended impact that regulatory measures could have on the build-up of systemic

risk.

C.1 Internal risks

Within the jurisdiction of securities regulators, a regulatory gap could arise from

unanticipated developments regarding:

i. activities that are currently regulated or, based on an assessment of their potential risk,

are regulated more lightly;

ii. activities in the exempt market, over which regulators or public authorities have

initially determined that less direct oversight is warranted for the protection of

investors; or

iii. new activities that regulators have yet to address.

36

Banking and currency crises and systemic risk: Lessons from recent events, Kaufman, George G.

Federal Reserve Bank of Chicago, Economic Perspectives, 24, August 2000, available at

http://www.highbeam.com/doc/1G1-65379501.html.

37 New Directions for Understanding Systemic Risk A Report on a Conference Cosponsored by the

Federal Reserve Bank of New York and the National Academy of Sciences, Economic Policy Review,

Federal Reserve Bank of New York, Nov 2007, available at

http://www.ny.frb.org/research/epr/2007n1.html.

27

In some cases, lighter regulatory treatment may be appropriate for activities and entities that

are determined to be of limited risk in the context of the securities regulators‟ mandate. Such

a determination is made by balancing the regulatory burden and the benefit to investor

protection and market efficiency.

Regulatory gaps occur when a particular market element requires oversight but is exempted

from any form of regulatory oversight (either by virtue of statutory or discretionary

exemptions). A possible unintended consequence of exemptions is that less oversight can

sometimes cause markets to be less transparent, which in turn can favour the build-up of

excessive risk. Such consequence highlights the need to revisit the underlying policy

considerations of the exempt market on an ongoing basis. This re-evaluation is critical as it

takes time to bring an exempt activity into the regulatory fold and there will likely be

resistance to such steps on the part of market participants.

Lastly, new market activities often result in regulatory gaps due to their complexity, the time

required to develop a proper and well-adapted regulatory response and the asymmetry of

information between the regulator and market participants. The risk created thereby will be

compounded if the element concerned has grown substantially in size or importance and

regulators require time to develop an appropriate response.

C.2 External risks

A regulatory gap can arise when a systemically important area of the market falls outside the

securities regulators‟ jurisdiction. Risk may find its source in instruments that, by definition,

do not constitute securities or in entities/markets over which securities regulators do not have

supervisory authority. It may be that the instrument, entity or market is supervised by

another regulator, but in a different way, or simply unregulated. In the first scenario, it will

be necessary for the securities regulator to cooperate and coordinate with the other regulator

in order to ensure securities regulators‟ concerns are addressed. In the second, consideration

should be given to bringing the area within its perimeter of regulation. By conducting regular

reviews of the perimeter of regulation, as proposed in IOSCO‟s new Principle 7, regulators

may uncover elements of their market that need to be monitored and/or regulated.

Regulatory gaps can be created when a market activity is duplicated outside the regulators‟

jurisdiction. Functionally similar activities should be regulated in a similar manner. In

addition, as the securities market is increasingly interconnected with the rest of the financial

system, risk can originate from other regulated segments, such as the insurance and banking

sectors. In such cases, the risk intersects or passes through the securities market (e.g. the US

sub-prime mortgage crisis). This reinforces the securities regulators‟ pressing need to take a

more active role in the global effort to address systemic risk.

C.3 Other implications

Securities regulators must be mindful that systemic risk will often, if not always, travel across

geographic boundaries and that regulation may unintentionally result in regulatory arbitrage.

Effective regulation will therefore require coordination and cooperation among securities

regulators internationally.

In addition, to avoid unintended consequences when developing or amending regulation,

28

securities regulators should take a longer-term approach and include systemic risk as a factor

in any impact analysis conducted.

Figure A: Systemic Risk in Emerging Markets and the Global Financial

Crisis38

This Figure focuses on the emerging markets‟ experience with the global financial crisis,

including the mechanism by which systemic risk was transmitted to such markets and the

response of their policy-makers and regulators.

The global financial crisis affected emerging markets in a different way from the experience

in many developed countries. IOSCO‟s Emerging Markets Committee (EMC) reported in

200939

that “[w]hile the direct exposure of emerging markets to sophisticated markets and

products has been typically low, their exposure to the secondary impact of financial

disruption may be just as high, if not higher, through global contagion. Indeed during the

credit crisis, the impact of financial distress was evident in emerging markets – especially

with regard to macroeconomic factors – even though the financial crisis primarily originated

elsewhere.” Since then, as shown in consecutive IMF World Economic Outlooks, the

financial and economic performance and outlook in many emerging markets has outstripped

that of more developed economies.

The differences arose for several reasons:

The build-up of financial system imbalances and systemic risk ahead of the crisis was

much greater in the developed countries than in many emerging markets, and the

crisis began in the global financial centres;

Many emerging markets were somewhat less interconnected with and less dependent

on the international financing centres than were some developed economies (partly

due to lesser fiscal and current account deficits in emerging markets and developed

country investors‟ reluctance to invest into longer-term emerging market assets);

Securities markets remain generally a proportionately smaller part of the financial

system in most emerging markets than in many developed countries, from the

perspective of both issuers and investors;

Many emerging markets had experienced severe systemic shocks in the recent past

and had taken policy steps to minimize the likelihood of a recurrence such as building

up large foreign currency reserves, which enabled them to meet portfolio outflows;

38

This note has many sources, including “Impact on and Responses of Emerging Markets to the Financial

Crisis, Final Report”, Emerging Markets Committee of IOSCO, September 2009 available at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD307.pdf; and a paper by Shyamala Gopinath,

Macro-Prudential Approach to Regulation – Scope and Issues, presented at the ADBI-BNM

Conference on Macroeconomic and Financial Stability in Asian Emerging Markets, Kuala Lumpur, 4

August 2010, available at http://www.bis.org/review/r100916d.pdf.

39 Impact on and Responses of Emerging Markets to the Financial Crisis, Final Report, Emerging

Markets Committee of IOSCO, September 2009, paragraph 29, available at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD307.pdf.

29

Continuing economic development gave many emerging economies sufficient

momentum to continue growing in the immediate aftermath of the crisis. This better

enabled them to respond to the adverse effects of the crisis. Low interest rates in

developed markets coupled with the potential for growth in developing countries

increased their attractiveness to investors relative to the developed economies; and

As a result, although emerging market economies faced severe outflows of short term

portfolio investment flows and had to institute a variety of emergency actions, the

impact on the real economy was less than in developed economies for the reasons

stated above.

The transmission mechanism that brought the systemic shock to emerging markets had some

special characteristics. As an exogenous shock (i.e. from outside), it came in three main

forms:

Trade finance froze in the 4th

quarter of 2008, and exports and imports experienced a

year-long sharp decline before a gradual recovery, which has been constrained by

weak demand growth in developed economies;

There was a sharp fall in domestic stock markets in emerging markets as short term

foreign portfolio inflows reversed immediately because investors needed to hold

liquid cash; and

There were problems in rolling over financings in foreign markets which had

temporarily frozen. However, very severe impacts were confined to those emerging

markets where foreign banks that had been hard hit in their home countries comprised

a big proportion of the domestic financial system (e.g. in many Eastern European

countries).

Emerging markets policy-makers and regulators did not have to respond as drastically to the

crisis as their peers in many developed countries. Nevertheless, the global financial crisis has

led many emerging markets securities regulators to be more cautious about financial

innovations and has heightened sensitivities over systemic risk.

Since the crisis, most major developed economies have adopted expansionary monetary

policies as part of their strategies to stimulate economic recovery. The liquidity so created

appears, at this stage, to be helping to support global growth and support some asset prices

without inflationary consequences. However, the liquidity creation also appears to be putting

upward pressure on some emerging markets‟ currencies and asset prices, increasing the

potential for portfolio inflows into those countries. In some cases, the currency pressures

have the potential to adversely affect the country‟s macroeconomic management.

The inflows into short-term debt and other portfolio investments represent a potential

systemic risk, which may crystallise into acute financial and/or economic difficulties for the

recipient economy if the inflows were to reverse sharply. Partly in response to these

concerns, some emerging markets have been looking more favourably at the use of controls

on capital inflows and exchange rate intervention or at other strategies to contain spill-over

effects from developed country financial and economic developments.

30

Chapter 3 Initial Considerations for Identifying Systemic Risks

This chapter proposes some approaches and indicators that securities regulators might use in

seeking to identify sources of systemic risk. The intent is to leverage existing approaches and

information available rather than duplicate the work done by others, in particular by

prudential regulators. The aim is to combine micro and macro-level indicators, which are

strongly linked to increases in systemic risk arising from the securities markets with the view

to inform securities regulators‟ action and policy.

The information that is currently being used by securities regulators for risk assessment can

also be used in assessing systemic risk. Furthermore, additional data from other regulators

can be compiled to look at flows and interactions between markets and jurisdictions and

assess potential spill-over effects. This approach is in-line with IOSCO‟s new Principle 6,

which states that “the regulator should have or contribute to a process to monitor, mitigate

and manage systemic risks, appropriate to its mandate.”

However, there are limitations in what is currently available in terms of systemic risk

measurements. A different set of data will need to be developed for systemic risk

measurement in securities markets. This information may come from other regulatory bodies

and national statistical agencies as well as other sources (including SROs, trade repositories

and CCPs).40

A prioritization of risks is necessary to be able to reduce or mitigate systemic risk. However,

prioritizing risks of various dimensions is not easily achieved. Existing approaches are at an

early stage of development and have yet to be tested.

Another consideration in developing the risk measurements is the fact that regulators in

various jurisdictions have varying levels of regulatory coverage and mandate. Some

regulators have a focus on securities markets alone while others have a broader mandate with

prudential supervision. It is important to highlight that not all indicators discussed in this

paper will be useful to a particular regulator. Given the nature of risk transmission in the

current financial systems and the impact on the different market participants‟ incentives and

risk taking, it is important to acknowledge that all regulators should be aware of the macro

environment they operate in. These issues are explored in greater detail in part B of this

chapter.

Finally, Figure B provides a practical example of how the Canadian Securities Administrators

(CSA) addressed the issue of identifying systemic risk in the Canadian securities markets.

A. What are securities regulators’ existing approaches to identifying risks and how can

they contribute to the identification of systemic risk?

A.1 Approaches for the identification of risk

Securities regulators, sometimes in conjunction with other financial supervisors in their

40

The reason the data here is referred to as “new” is because it is new to securities regulators‟ role in

systemic risk measurement although many of the datasets described in section B already exists (for

example, data related to fiscal debt sustainability, movement of international capital, and the

geopolitical environment).

jurisdiction, have different approaches to identify risks, which they use to determine their

appropriate regulatory and supervisory efforts. Risk identification approaches typically

contain a combination of analysis of risks within individual financial firms, issuers, products,

transactions or markets. Risks within regulated entities are identified through regular contact

with individual firms and the analysis of the firm‟s regulatory filings. Regulators assess

solvency via the firm‟s balance sheet, external and internal risk and audit reports. Regulators

also analyse the products and the processes of the firm, assess customer complaints and

sometimes have discussions with senior management within the firms.

The risk identification process at the firm level can be followed up by an analysis of the risks

that can have a broader impact on the markets or market segments in which the firm operates.

Regulators share internally their views on these risks and conduct additional top-down

analysis of risks.

Typically a top-down analysis of risk involves identifying risks that can affect the well-

functioning of the market through the analysis of existing data on markets, products and

market segments.41

Some regulators also survey or otherwise reach out to market participants

to collect information on their risk exposure. Regulators map trends in relevant markets and

study market behaviour. They look into operational risks, financial risks and risks of fraud.

Commonly they analyze issues including:

product markets and concentrations of holdings;

debt and leverage of households and firms;

the complexity of products or services;

opacity and lack of disclosure, the pricing of products and services;

incentive structures; and

innovative products, services and technologies.

Following the financial crisis, regulators have stepped up their focus on risks and tried to

address some of the challenges inherent to the risk identification process, such as the sharing

of information across silos. For instance, the U.S. Securities and Exchange Commission has

created a new division, called the Division of Risk, Strategy and Financial Innovation, and

several regulators have established internal risk committees (refer to Figure B on the

Canadian experience). At the European Union level, the Committee of European Securities

Regulators (CESR) set up the Committee for Economic and Markets Analysis (CEMA)

devoted to the identification, monitoring and assessment from a micro-prudential level of

trends, potential risks and vulnerabilities in financial markets across borders and sectors,

including financial innovation and incentives related to market practices both at the wholesale

and retail level. Further, securities regulators are starting to use the information they gain

through their day-to-day work and collection of data to identify potential misconduct or

threats to market integrity, in order to also identify potential threats to financial stability. For

example, the UK Financial Services Authority collects information on hedge funds in terms

of their potential to generate systemic risk. Market surveillance data, which are traditionally

41

New post-crisis legislation in some jurisdiction where mandated use of trade repositories may assist in

this regard.

32

being used to track price manipulation or insider trading, can also be used to monitor trends

in the markets (such as the growth of high-frequency trading, and increase in liquidity and

volumes to measure the maturing of a market and new entrants) and assess possible

consequences42

.

Securities regulators can also use the information they collect to identify specific trends in

products or securities offerings. In particular, the EU‟s new Alternative Investment Fund

Managers Directive will allow national authorities to collect data on the leverage used in

alternative investments and to convey it to ESMA, which in turn will make a collective

analysis of the levels of leverage. Taking into account the advice of the ESRB on this matter,

ESMA may determine that the leverage used by an alternative investment fund manager

(AIFM) or by a group of AIFM poses a substantial risk to the stability and the integrity of the

financial system and may issue an advice to competent authorities specifying the remedial

measures to be taken.

Although existing and developing approaches are not focused on the identification of

systemic risk per se, they can be used to detect early signals of accumulation of risks and

thereby contribute to the macro-prudential oversight of the risks in the financial system. In

addition, new and more integrated approaches using a broader range of “red flags” should

also be explored.

A.2 Approaches for the identification of Systemic Risk

In the current regulatory environment, there are a limited number of approaches employed by

securities regulators with respect to identifying systemic risk. The existing approaches have

not evolved into best practices, which may reflect the varying regulatory coverage of

regulators as well as the early stage of development of systemic risk identification in

securities markets.

Many regulators in the financial sector are currently developing approaches for identifying

systemic risk and promoting financial stability. Most of the work, to date, has been done by

prudential regulators and focuses on the banking perspective.

The challenge for securities regulators in adapting the prudential regulators‟ approaches is

that they are not easily applied to securities markets. As a result, new approaches are needed

to address systemic risk in a way that incorporates the intricacies of securities markets and

the interplay between the various market participants.

The approach of securities regulators should initially focus on an analysis of the policy

settings that foster an environment in which there are improper incentives for risk taking.

Less risk-aware firms and investors can take on greater risk without a proper appreciation

thereof. This leaves the more risk-aware firms with the choice of either joining in or risk

losing market share (for example by not distributing nor investing in a product), thus driving

the accumulation of risks in the system. An example from the recent financial crisis is the

widespread distribution of and investment in securitized sub-prime assets by investment

banks.

42

See for example, AMF, Working Paper n°9, Equity trading: A review of the economic literature for the

use of market regulators, and especially, Chapter 3 which uses AMF market surveillance data

(http://www.amf-france.org/documents/general/9541_1.pdf).

33

Another useful way of uncovering systemic risk is to look for knowledge gaps. Knowledge

gaps can be more prevalent in the case of new or complex products, services and

technologies. For example, investors typically do not appreciate the full spectrum of risks

attached to more complex products.

Finally, it is important to identify where we have data gaps and try to fill these gaps with

qualitative information such as regular intelligence gathering meetings with market

participants. Often, the lack of easily available quantitative data can lead to regulators not

focusing on potential risks. Qualitative information can help identify a potential problem and

lead to more data gathering or surveys in that area.

A.3 Identification of Systemic Risk at a global level

Since the global financial crisis, there has been an elevated level of concern about the

identification of systemic risk within securities markets, in particular, at the global level.

This concern has prompted IOSCO to start building a research capacity. The organization

has adopted a strategic direction which emphasizes the need for securities regulators to seek

to identify, monitor and manage systemic risks. This Discussion Paper initiates the process

of developing an approach for assessing systemic risk. The approaches under development

will take into consideration the major issues being faced by regulators in assessing systemic

risk.

At a global and regional level, the BIS, FSB, IMF, World Bank and ECB are developing

various systemic risk frameworks, complemented by significant academic work. These

approaches, mostly theoretical and from a banking perspective, could provide some guidance

to the development of systemic risk approaches for the securities markets and will contribute

to the dialogue between prudential and securities regulators on systemic risk.

B. Initial considerations in developing Systemic Risk indicators for Securities

Regulators

This section offers a starting point from which securities regulators can consider indicators of

systemic risk. The specific indicators that are listed in Appendix A are exploratory at this

stage and are not meant to be exhaustive. Further work is needed to develop a better

informed approach to achieve all encompassing measurements of systemic risk. More

importantly, there needs to be sufficient consideration given to the practical application of

macro level indicators that are traditionally tracked by prudential regulators or central banks.

The intention here is to provide possible indicators of systemic risk which are relevant to the

securities markets. While not a part of securities regulators‟ traditional toolkit, awareness of

macro indicators can be most appropriate when developing early warning signs or red flags.

Chapter 2 of this paper included discussion of sources of risk and transmission mechanisms.

Once a systemic risk becomes apparent through the transmission mechanisms it is much more

difficult for a regulator to restore confidence in the market. As such, securities regulators

should focus their efforts on indicators directed at sources of systemic risk. However,

transmission mechanisms for systemic risks purposes should be well understood by securities

regulators to better understand how the sources of risk may be interconnected. In particular,

new developments which impact the transmission mechanisms, such as CCPs, as well as

through the development of new services or products should be closely monitored.

34

B.1 Possible approaches in applying the indicators to assess Systemic Risks

The first task for securities regulators (and IOSCO) is to calibrate the systemic risk measures

in practice. There will be considerable trial and error in coming to an assessment, on an

aggregate basis, of the extent of systemic risk prevailing in the financial system. This

assessment of systemic risk is a new task for most securities regulators and those that have

the capacity to undertake the tasks should share their expertise and outcomes with others.

Some of the tools which could be developed by securities regulators to address systemic risk

include scenario analysis and stress testing. These two methods complement and build on the

indicators listed in Appendix A by identifying how and under what circumstances a build up

of risk can turn into a systemic event, and therefore how and when regulators should respond

to emerging risks.

Scenario analysis and stress testing can provide insight of the size of the risk, and if there is

sufficient data available, even a reasonable measurement of the exposure. An example of a

scenario analysis for a securities regulator addressing systemic risk is the simulation of an

interest rate shock on the financial position of households and on the financial institutions by

the AFM of the Netherlands.43

The analysis provided insight on the potential vulnerability of

the financial system in the case of an interest rate shock, which also had securities market

implications through unit linked mortgages held by banks.44

The French AMF also recently

analysed the potential effects of rebalancing leveraged and inverse ETFs on the underlying

equity market assuming various changes in the index45

. Other scenarios could involve stress

testing market infrastructure providers or the impact of the failure of a major player in a

market.

B.1.1 Qualitative and quantitative approaches

An effective assessment of systemic risk will always draw on two distinct but complementary

approaches: a detailed and well developed quantitative data architecture based on robust data

and a qualitative assessment that relies more heavily on expert views and local jurisdictional

experience. Initially, IOSCO will have to rely more on a qualitative approach since the data

required for a more quantitative approach is lacking. In the future, the availability of data

will improve, and more quantitative approaches can be developed, either through the

collection of data at a global level through IOSCO‟s research capacity (i.e. Research Unit) or,

to the extent permitted by national law, through its members.

The first step in a systemic risk analysis is to conduct an assessment of the potential impact

under certain scenarios in order to prioritize those risks. The potential impact of a risk should

be quantified in absolute monetary terms or be expressed as a proportion of a relevant

benchmark, such as the asset market size or the infrastructure providers‟ balance sheet in

order to get a sense of scale and the interconnectedness to the system (qualitative impact

43

Interest Rate Risk. The Consequences of an Interest Rate Shock for Households in the Netherlands,

2005, AFM.

44 Amongst others, unit linked mortgage was a product in the Netherlands that had a strong link between

household finance and the securities markets.

45 Effects of rebalancing leveraged and inverse ETFs on the underlying equity market, Economic and

Financial Newsletter, pp. 7-12, December 2010, AMF.

35

determination).

Given the lack of data, precise estimates of an impact will often not be achievable.

Sometimes data will only be available for one country, one market segment or one firm. In

such cases, scenario analysis and stress tests cases will be carried out by extrapolating data in

order to give an indication for other jurisdictions and/or the global market.

A second step in the risk analysis and an even more difficult task is the

determination/assessment of a probability of a systemic risk turning into a systemic event.

Again, scenario analysis and stress testing will only give insight on the possibility that an

event may occur. However, since it is extremely difficult, if not impossible, to foresee the

timing of large impact events, one can expect only to determine a scale of high, medium and

low probability, if at all.

Finally, the approach should classify the risks by linking the potential impact and the

probability together. The resulting classification is important to prioritize the mitigation

efforts of regulators and IOSCO. One possibility might be to classify in a simple scheme:

red, amber and green alert, with a red alert potentially requiring a prompt IOSCO and/or

regulatory action to mitigate this risk.

B.1.2 Systemic Risk indicators and the financial crisis

One beneficial use for this approach would be to see how it might have performed during the

most recent crisis and use the results to help identify lessons learned. A good warning

system would have indicators that moved from green in the early nineties to amber and then

to red in the mid-2000s, as leverage built up and risks developed, accumulated and became

concentrated. Many of the indicators identified (in Appendix A), when fully developed,

should reproduce such a progression. For instance:

Macroeconomic indicators would have shown above average credit growth,

abnormally low risk-adjusted cost of credit, considerable asset overvaluation as well

as large and concentrated international capital flows;

Micro indicators would have shown rapid growth in new credit products and

investment vehicles, heavy asset concentrations among SIFIs, heavy reliance on

quantitative risk modelling and credit ratings and growing uninsured exposures to

credit market liquidity mismatches;

Size indicators would have shown tremendous growth in CDOs, CDSs, balance

sheets, and leverage;

Interconnectedness indicators would have revealed expanding and intensifying

counterparty exposures and credit market exposures, both within jurisdictions and

internationally;

Transaction indicators showing the positions and valuations of those positions would

have assisted in identifying concentrations in the industry;

Concentration indicators would have revealed increasing exposures among SIFIs to

overpriced assets whose risks had been severely underpriced;

36

'Behavioural' indicators would have shown worrisome trends in business models,

investment strategies and risk exposures; and

'Regulatory' indicators would have revealed strong growth in unregulated and lightly

regulated market segments, and evidence of regulatory arbitrage.

The challenge is obviously to identify indicators also able to spot future vulnerabilities.

B.2 Issues and challenges

B.2.1 Issues with data collection and risk measurements

Although there is a consensus at the international level to develop systemic risk

measurements and provide analyses and solutions to mitigate those risks, there are some

strong reservations on the effectiveness of such an approach given the complexities in

aggregating such measures. The existing data is fragmented with gaps in data availability.

Timeliness of the data is also a concern as much of the existing data takes time to compile

and release, increasing the risk that this data may be 'stale' or out of date by the time it is

available to regulators. Stale data may still offer some value after the fact but may be of little

use in predicting upcoming crises. On the international front, data comparability is an issue

given the inconsistencies in securities market data. For example, there is no consensus on

risk measurements such as leverage. This factor further limits the ability to use data in risk

measurement that often involves aggregation of risks.

The need for better data is also addressed by the FSB and IMF in their report titled The

Financial Crisis and Information Gaps.46

A key area of concern is the lack of data

availability at the international level as supported by two key points in the report:

Closing all the gaps will take time and resources, and will require coordination at

the international level and across disciplines, as well as strong high-level support.

The legal framework for data collection might need to be strengthened in some

economies.

Flexibility and prioritization in the timetable of implementation will be needed to

account for the countries’ level of statistical development and resource

constraints.

B.2.2 Legal ability to share information across regulators globally and within a

country (between the prudential and the markets regulator)

Regulators are in a position to collect market information legally and going forward they

should exercise their powers to collect timely and relevant information to feed into the

approaches under development. Sharing information both regionally and internationally will

provide an added dimension that is very important to understand risk development as it has

been proven from the recent financial crisis, which was global in nature even though the

source was very much local.

46

Supra note 7.

37

The ESRB stresses the importance of the development of an appropriate infrastructure for

pooling such information on an EU-wide basis which will require substantial analytical and

data-related expertise, as well as market knowledge. Work is already under way to set up

procedures for regular information-sharing between the ESRB and the European Supervisory

Authorities47

. Information-sharing will also have to be strengthened at the international level.

B.2.3 Cooperation

Traditional risk measurement approaches do not take into account the interconnectedness.

There needs to be a new model that takes into account the impact from non/less-regulated

entities such as shadow banking, alternative trading systems (ATSs), and non-bank lending

institutions. There is also difficulty in forecasting trigger events and human behaviour, as

well as foreseeing asset bubbles. All of these measures are difficult to quantify. To resolve

some of these concerns a multidisciplinary approach is needed where all

participants/regulators would coordinate an international and comprehensive approach to

systemic risk measurement.

The modern information infrastructure is conducive to the sharing of timely information as

long as there is an agreement to do so. In order to facilitate this, there needs to be an

internationally coordinated effort for data collection and sharing in order to better assess risks

emanating from various regions of the world.

B.2.4 Resource constraints

Additionally, the lack of technical resources for systemic risk analysis is an obstacle in

effectively monitoring and mitigating systemic risk and is encountered by securities

regulators worldwide. Securities regulators have traditionally focused on market conduct and

could lack some of the skilled professionals such as economists and statisticians as well as

financial analysts with market experience that are needed to develop systemic risk analysis

frameworks. Similarly, many regulators will need to build the IT infrastructure needed to

store and analyse large volumes of data. These are important factors that influence the ability

not only to develop new methods to measure systemic risk, but also to better use the existing

data, information and expertise needed to monitor and mitigate systemic risk.

Figure B: The Canadian Experience

Assessment of Systemic Risk in the Canadian Securities Market

In October 2009, the Canadian Securities Administrators (CSA)48

formed a committee (the

47

The three European Supervisory Authorities are the European Securities Markets Authority (ESMA),

the European Banking Authority (EBA) and the European Insurance and Occupational Authority

(EIOPA).

48 The Canadian Securities Administrators (CSA) is a voluntary umbrella organization of Canada‟s

provincial and territorial securities regulators whose objective is to improve, coordinate and harmonize

regulation of the Canadian capital markets, to ensure the smooth operation of Canada‟s securities

industry and to ensure close collaboration in securities law enforcement. The CSA‟s mission is to give

Canada a harmonized securities regulatory system that (a) provides protection to investors from unfair,

improper ofr fraudulent practices, (b) fosters fair and efficient capital markets, and (c) reduces risks to

market integrity and to investor confidence in the markets, while retaining the regional flexibility and

innovation that characterize the Canadian system of provincial and territorial regulation.

38

Committee) to develop processes to identify, analyse and monitor systemic risk in the

Canadian securities markets, to make an assessment of existing systemic risk therein and to

make recommendations on potential steps to mitigate the identified systemic risks. Members

assigned by the various participating provincial and territorial securities regulators to the

Committee have a diverse range of experience in securities regulation.

The Committee developed an assessment process based on defining systemic risk from the

perspective of securities regulators and categorizing the securities market in a top-down

fashion. This approach considered groups of entities and market activities in addition to

single entities of significant size and importance. Initially, the Committee identified seven

key elements of the Canadian securities market: market participants, markets, market service

providers, clearing and settlement systems, investment products, selling practices and market

activities, and regulators and/or other oversight organizations. Within these elements, the

Committee identified over 50 categories for consideration of the types of risk. Of these

categories, the following were selected for more in-depth study: OTC derivatives, clearing

and settlement systems and central counterparties, hedge funds, direct market access,

electronic trading, credit rating organizations, repos, securitized investments, investment

dealers, custodians and commodity indices. In addition, the Committee investigated the role

that each of counterparty risk, funding liquidity risk and market liquidity risk play with

respect to systemic risk. For each of the selected categories, the Committee assessed the

potential for systemic risk based on the guidance from the FSB/IMF/BIS October 2009

report49

. As part of the assessment of systemic importance to securities regulators, the

Committee also considered jurisdiction and the perimeter of regulation.

After prioritizing the categories on a preliminary basis, the Committee began identifying

specific sources of systemic risk. The identification of systemic risk was conducted through

a variety of methods including academic review and consultation with subject-matter experts

within the CSA or other regulators. The potential systemic risks that were identified most

commonly stemmed from actual or potential concentration, interconnectedness, large

counterparty exposures and opacity. Less frequently, the identified risks reflected high levels

of potential leverage, moral hazard and market innovation/regulatory gaps. The Committee

also identified potential causes for each risk and potential mitigation steps, including

monitoring of existing or new data, amending regulation or policy, and further cooperation

with other regulators. In many cases, the Committee concluded that some areas of potential

concern were already being considered as part of the existing policy development process

within the CSA. For example, CSA committees were already considering steps to address

risks associated with OTC derivatives and credit rating agencies.

49

FSB, IMF and BIS (2009) supra note 7.

39

Chapter 4 Mitigating Systemic Risk and Promoting Financial Stability

This chapter gives guidance to securities regulators on how they might work to reduce the

likelihood and severity of outbreaks of financial instability in their jurisdictions. The

measures are mainly preventative in effect. The aim is to create the conditions under which

market participants can more accurately manage their risks and price those risks, and interests

of agents, intermediaries and gatekeepers can be more strongly aligned with those of

investors.

Should systemic risk nevertheless emerge, and regulators indicator boards begin flashing red,

tools available to regulators can also be used in whatever fashion is appropriate for mitigating

developing risks. For example, the development of high degrees of leverage and

concentrations of risk in a lightly-regulated segment of the market can be met with the

introduction of greater transparency regarding open positions and exposures, limits on

participants‟ leverage as well as a communications strategy aimed at bringing potential risks

to the market‟s attention.

However, the tendency for systemic risk to emerge in areas outside of securities regulators‟

control, such as the macroeconomic environment, means that they can arise in spite of the

best efforts of regulators to create well-functioning, transparent and efficient markets that are

rich in information.

In such instances, securities regulators should, sometimes acting in conjunction with other

financial market supervisors, raise the risk awareness (of market participants, other regulators

and legislators) so as to limit the development and accumulation of risks and thereby mitigate

the impact of risks posed to the financial system.

The first part of this chapter reflects on the findings of the earlier chapters and describes the

policy and regulatory tools available to securities regulators which can help prevent the

development of systemic risk in the system. The second part of the chapter describes

IOSCO‟s current and developing role with respect to systemic risk.

A. Tools available to securities regulators

Securities regulators have specific tools that can reinforce the stability of the financial

system. Actions can be taken to address both risk transmission mechanisms as well as

sources of systemic risk emanating from within or passing through securities markets.

Securities regulators should carefully consider unintended consequences that may follow

from any risk mitigating measures, taking into account, inter alia, the degree to which a new

measure may invite compliant behaviour that may actually increase correlation or construct

new feedback loops. For example, before imposing a new measure, regulators should

consider if it could cause market participants to adopt similar behaviour to such a degree that

it would decrease market diversity. Also, introducing a measure may merely move the

problem elsewhere, or may even concentrate it and thus may introduce a “single point of

failure.”

In order to minimise the chance of being confronted with unintended outcomes, any

measures taken should be proportionate to the identified risks. Also, while such measures

will often aim to mitigate risks that are international in nature, they have to be tailored to the

40

needs and particularities of the market in which they are to be implemented.

The following section describes the tools available to securities regulators.

A.1 Policy and regulatory tools

Interventions by securities regulators can be grouped into five broad categories:

i. transparency and disclosure;

ii. business conduct oversight (rules and other interventions aimed at shaping the

behaviour of market participants);

iii. organisational, prudential and governance requirements;

iv. prevention of risk transmission; and

v. emergency powers.

These forms of intervention can be useful in addressing the various sources of systemic risk

once they have been identified. For instance:

Risks arising from size and interconnectedness can be reduced through:

o limiting the exposure one entity can have to another, or restricting the presence

of common personnel across interconnected entities (such as shared company

directors) or disclosing potential conflicts of interest arising from such shared

company directors;

o requirements to disclose the extent of exposure to other entities; and

o business conduct rules – e.g. limiting the conflicts of interest which can exist

in the conduct of normal business.

Lack of transparency can be resolved by introducing more stringent product and

market disclosure requirements.

'Lack of substitutability' and 'concentration' issues can be addressed by introducing

policies which encourage competition and putting in place market rules such as large

trader reporting requirements and position limits.

Risks arising from leverage can be addressed directly through prudential requirements

which limit the amount of leverage taken on by an entity, or indirectly via disclosure,

imposition of obligations or other incentives.

Issues relating to market participants behaviour can be mitigated through

organisational and governance requirements (e.g. those targeting remuneration

practices).

It is important to note that greater transparency and strong business conduct oversight are not

41

only mitigating tools but can also be reliable identifiers of emergence of systemic risk in the

market (see Chapter 3 above).

A.1.1 Transparency and disclosure

Transparency is fundamental for price formation, assessing risks, overcoming information

asymmetries and maintaining market confidence. It also establishes standards that permit the

marketplace to contribute constructively to policing excessive risk taking. The traditional

tools of transparency and disclosure will help securities regulators identify concentrations of

risk that may warrant further regulatory or legislative responses. It is the responsibility of

securities regulators to ensure the appropriate level of transparency about products and

markets and the integrity of information provided to the market.

Product transparency

Enhancing the transparency around financial products should give investors the necessary

information to assess the risks attached to them and, as a result, make better investment

choices. Opacity, especially in an overconfident market, can encourage collective behaviour

which can lead eventually to widespread losses, with adverse consequences for the real

economy.

Improved transparency also enhances investors' ability to conduct their own internal risk

assessments of investment products. The G-20 has recommended the removal of regulations

which encourage investors to rely exclusively on external credit ratings. The new regulatory

frameworks for credit rating agencies will also foster greater transparency in their

methodologies. Enabling institutions to better understand external ratings and to expand their

internal credit risk assessments will ensure better discipline and reduce the potential for

systemic instability.50

Market transparency

Market transparency contributes to an effective price formation process and to the integrity of

markets. At the same time, it can facilitate the detection of potential risks and help contain

panic in times of stress. The reform of the OTC markets, including the development of trade

repositories and the promotion of more exchange trading and centralised clearing, will greatly

increase transparency to both regulators and market participants. Other initiatives are being

considered in the U.S. and Europe regarding commodity derivatives markets (e.g. CFTC‟s

weekly publication of its Commitments of Traders report) or, in Europe, the disclosure of

information regarding net short positions, above certain thresholds, to the regulators and to

the market (the proposal covers both shares and sovereign bonds).

The March 2009 Commodity Task Force report51

built on these initiatives, and called on all

futures markets regulators to have access to information that permits them to identify

concentrations of positions and the overall composition of the market, including the authority

to access a traders‟ related financial and underlying market positions. Jurisdictions were

50

The Financial Stability Board, of which IOSCO is a member, has developed a set of principles to

reduce reliance on credit ratings: see http://www.financialstabilityboard.org/publications/r_101027.pdf

51 Task Force on Commodity Futures Markets, Report of the Technical Committee of IOSCO, March

2009, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD285.pdf.

42

called upon to review the scope of their authority, and if necessary, take affirmative steps to

request the necessary powers legislatively.52

While these recommendations were made in the

context of commodity derivatives, they are equally applicable in other markets.

In the equity markets, the flash crash of May 6 2010 highlighted some transparency risks, as

delays and complexity in obtaining and aggregating market data to form a complete picture of

the different trading facilities may have exacerbated uncertainty in the market and contributed

to liquidity drops.

As for the fixed income markets, where the bulk of the transactions are OTC, some regulators

have analysed the implications of the lack of transparency, focusing especially on investor

protection and price formation consequences. This is the case in the U.S. where the corporate

bond market has had a mandatory reporting system since 2002. In the E.U., the issue is still

under discussion. Now, in the aftermath of the financial crisis, securities regulators should

also take into account the usefulness for financial stability monitoring of having available

more price and volume information in the fixed income markets.

Financial and risk disclosure

Accurate financial and risk disclosure is important for market participants because:

it is essential to maintaining the confidence of shareholders;

it potentially impacts market confidence generally;

as shown during the financial crisis, it allows broader monitoring of financial

soundness indicators and risks accumulating in the financial system; and

perhaps most importantly, a disclosure framework facilitates the pricing of risks and

investments.

Securities regulators focus on full financial and risk disclosure in the interest of investor

protection and market integrity. In contrast, prudential regulators often emphasise the

importance of confidentiality to manage the risks of potential runs on financial institutions in

crisis situations. The financial crisis and other recent developments suggest that transparency

and disclosure have become essential from a prudential perspective. A good example of the

importance of transparency is the publication of the stress test results for the banking sectors

in the United States (July 2009) and in Europe (July 2010) and detailed information about

individual banks‟ exposures to specific products risks that markets were concerned about.

These removed some uncertainty in the market by giving investors information to help them

assess the size of capital gaps or to extrapolate additional stress scenarios for specific

institutions.53

In the wake of the financial crisis it has also become routine for banks to

52

Task Force on Commodity Futures Markets, Report to the Technical Committee of IOSCO, March

2009, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD285.pdf. See also the recent

OR08/10 Task Force on Commodity Futures Markets Report to the G-20, November 2010, available at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD340.pdf.

53 See for instance, Donald P. Morgan, Stavros Peristiani, Vanessa Savino, The Information Value of the

Stress Test and Bank Opacity, Federal Reserve Bank of New York, Staff Report n°460, July 2010;

available at http://www.ny.frb.org/research/staff_reports/sr460.html. ,Stress-testing Banks in a Crisis,

pp. 117-125, Financial Stability Review, European Central Bank, December 2010 available at

43

disclose information on capital ratios that had traditionally been treated as confidential.

Regarding risk disclosures in general, the implementation of the Financial Stability Forum‟s

2008 recommendations is currently under review; the general objective being to ensure

reliable valuations and disclosures of the risks that are most relevant to market conditions at a

particular time.54

A.1.1 (a) How might enhanced transparency and disclosure have helped mitigate the

crisis?

Enhanced transparency and disclosure might have mitigated the risks which helped create the

crisis by showing more clearly to regulators and market participants the problems that were

emerging in the financial system. Greater transparency might also have filled the knowledge

gaps which resulted in an under-pricing of risk in the lead up to the crisis.

Rules which encourage institutional investors to use their own risk assessments alongside

those of credit ratings agencies, rather than encouraging them to rely exclusively on those

ratings, might have tempered the strong demand for sub-prime securitised assets and

encouraged pricing which more accurately reflected the risks that they carried. The use of

trade repositories and centralised clearing of derivatives contracts would have allowed

regulators and market participants to identify accumulations of risks at financial institutions,

such as AIG, and to check that these risks were being managed and insured against

adequately. As for financial sector stress tests, they might have identified threats to the

financial system arising from changes in the macroeconomic environment, such as falls in

demand for housing.

A.1.2 Business conduct oversight

Securities regulators have the primary responsibility for business conduct oversight. This

includes rules directed to the qualifications of market participants and to managing or

prohibiting conflicts of interest.

The recent global financial crisis highlighted the extent to which investor protection issues,

combined with weakened diligence from investors, can lead to systemic risk. Indeed, the

crisis has demonstrated that consumer problems with the promotion and distribution of sub-

prime mortgages were an early warning signal, indicative of a deeper systemic problem.

Strong regulation and oversight of market intermediaries and other market professionals are

thus necessary to ensure sound business practices and the protection of investors‟ interests,

and to contribute to financial stability. In particular, business conduct rules need to address

conflicts of interest, including the prohibition of inappropriate practices in certain cases.

Furthermore, active enforcement of the rules is also necessary, as this clearly influences

market participants‟ behaviour and can limit the development of risks.

When considering the potential for undesirable selling practices, securities regulators should

take into consideration economic incentives (for instance, heavy reliance on commission-

http://www.ecb.int/pub/fsr/shared/pdf/ivafinancialstabilityreview201012en.pdf?d80416324a10f3cb414

9e717e226311e. 54

FSB invites feedback on risk disclosure practices, Financial Stability Board, July 2010, available at

http://www.financialstabilityboard.org/press/pr_100721.pdf.

44

based remuneration driving churning), and the impact of economic and financial conditions

on the business models of the different types of market participants (for instance, the search

for yields in the context of a prolonged period of low interest rates) as well as product

characteristics (e.g. complex products). In some cases, regulators should be able to increase

business conduct requirements; they should also be able, together with the systemic risk

bodies in their respective jurisdictions, to restrict certain activities which might threaten the

overall stability of the financial system.55

A.1.2 (a) How might enhanced business conduct oversight have helped mitigate the

crisis?

Actions aimed at changing incentive structures in order to better align the interests of

financial intermediaries and agents more closely with those of investors would have helped

address risks which arise from conflicts of interest. Ensuring intermediaries who promoted

securitised products be exposed to similar risks as they were passing on to investors, and to

face consequences resulting from investor losses, might have encouraged a critical appraisal

of the value of those securitised products. It might have also allowed investors to move their

business away from agents who shied away from such risk sharing.

More active monitoring of business models and practices by securities regulators might also

have alerted regulators and investors to emerging problems at financial institutions.

A.1.3 Organisational, prudential and governance requirements

These requirements provide incentives to market participants to better manage the risks

which may have systemic impacts; in short, they provide incentives to internalise

externalities to the firm. These could include risk based prudential requirements,

requirements about risk management and compliance functions and broader governance

arrangements (including principles about compensation) and arrangements which support

effective management of conflicts of interest. In particular, supervisors should put more

emphasis on qualitative assessments of risk management techniques and culture within firms,

rather than leaving the onus solely on the firms to comply with a series of requirements. This

would prevent the exercise from becoming a mere mechanistic one by both the firms and

regulators.

Following IOSCO‟s initial report on the subprime crisis, published in 2008,56

securities

regulators have reviewed internal control systems of financial firms to assist with and

supplement the work undertaken the Basel Committee on Banking Supervision (Basel

55

The European Securities Markets Authority, ESMA, “may temporarily prohibit or restrict certain

financial activities that threaten the orderly functioning and integrity of financial markets or the

stability of the whole or part of the financial system in the Union (…) or if so required in the case of an

emergency situation (…)”. In the United States, the Financial Stability Oversight Council‟s response to

“grave threats” includes limiting the ability of the company to merge with, acquire, consolidate with, or

otherwise become affiliated with another company; restricting the ability of the company to offer a

financial product or products; requiring the company to terminate one or more activities; imposing

conditions on the manner in which the company conducts one or more activities; or, if the Board of

Governors determines that [such] actions are inadequate to mitigate a threat (…), require the company

to sell or otherwise transfer assets or off-balance-sheet items to unaffiliated entities.

56 The Role of Credit Rating Agencies in Structured Finance Markets, Report of the Technical Committee

of IOSCO, Consultation Document, March 2008, available at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD263.pdf.

45

Committee). IOSCO‟s August 2010 Consultation Report on Intermediary Controls

associated with Price Verification of Structured Finance Products57

discusses issues such as

analytical capabilities for price verification, risk culture and governance processes, tests and

hedging strategies; the document also shares observations on best practices. This work

stresses again the role of market prices and the importance for market participants to assess

correctly prices and liquidity in order to understand the actual level of risk for the firm.

Additional risks are discussed, such as the concentration of positions and the building up of

positions. Lastly, the document highlights the role of supervisors and other tools to help

discourage or prevent excessive risk taking, such as imposing restrictions on firms from

engaging in a particular line of business where the firm falls below certain capital levels or

where the firm violates other material requirements imposed by the regulator.

While most efforts have focused on banking institutions and securities firms, a significant

change since the crisis has been a new focus placed on the risk management practices of asset

managers. An IOSCO report published in July 2009 focuses on investment managers‟ due

diligence when investing in structured products.58

More recently, in Europe, new rules oblige

asset managers to employ sufficiently robust and effective procedures and techniques so that

they are able to manage adequately the different types of risk that their assets under

management might face. Periodic back-tests and stress tests will likely become more

widespread, and there will be more emphasis on the independent assessment of the value of

OTC derivatives positions. These developments, which will require significant efforts in

terms of resources and skills at the level of the asset managers, will foster better and more

continuous assessment of risks and contribute to restraining excessive risk taking.

A second important matter to address is remuneration. The principles and implementation

standards on remuneration developed by the FSB seek to avoid excessive risk taking and

prevent conflicts of interest by aligning remuneration practices with risk management.59

They have been translated into banking regulation and the FSB has conducted a peer review

of implementation. The results published in March 2010 highlight notably the need for

convergence and coordinated efforts to prevent regulatory arbitrage and transfers of risks

between jurisdictions or between various parts of the financial system.60

Those principles on

remuneration are now finding an echo in the rest of the financial industry (for instance, in the

European asset management industry)61

, while taking into consideration the specificities of

57

Intermediary Internal Controls Associated with Price Verification of Structured Finance Products and

regulatory Approaches to Liquidity Risk Management –Consultation Report Report of the Technical

Committee of IOSCO, August 2010, available at

http://www.iosco.org/library/pubdocs/pdg/IOSCOPD331.pdf

58 Good Practices in Relation to Investment Managers' Due Diligence When Investing in Structured

Finance Instruments, Report of the Technical Committee of IOSCO, July 2009,

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD300.pdf.

59 FSB Principles for Sound Compensation Practice, Financial Stability Board, 25 September 2009,

http://www.financialstabilityboard.org/publications/r_090925c.pdf.

60 See Thematic Review on Compensation, Financial Stability Board, 20 March 2010, available at

http://www.financialstabilityboard.org/publications/r_100330a.pdf. The report notes material progress

in areas such as governance, supervisory oversight and disclosure but identifies several issues yet to be

resolved in order to raise standard of risk adjustment to pay structures across the industry. It

recommends additional measures and further convergence, as well as expanding the coverage of

significant nonbank financial institutions.

61 At the European level, the Alternative Investments Funds Managers Directive (AIFM) requires that

managers set-up remuneration policies and practices, notably being consistent with the effective risk

management and designed to avoid non-appropriate risk taking. The future round of European

46

the various business models involved.

A.1.3 (a) How might enhanced organisational, prudential and governance

requirements have helped mitigate the crisis?

A key lesson learned from the financial crisis was that many market participants

misunderstood the nature of the risks attaching to their investments and underestimated the

scale of those risks. Regulatory standards outlining how asset managers should assess risks

would have encouraged a greater understanding of the risks developing in financial systems

around the world, so thereby encouraging a more accurate pricing of those risks and

contributing to their mitigation. Combining these standards with limits on risk taking would

have further attenuated the risks.

Another key lesson of the crisis was that poorly designed incentive structures can encourage

imprudent risk taking on a scale sufficient to threaten financial stability. Having

remuneration aligned more closely with risk management would, as with the measures noted

above, have helped mitigate systemic risk by encouraging a more accurate pricing of risks.

A.1.4 Prevention of risk transmission

Securities regulators can use different policy and regulatory tools to prevent or limit

contagion/risk transmission.

Trading rules

In the new trading environment characterised by the increased speed of transactions and high

level of integration between markets, trading infrastructures must be subject to strong rules

to prevent outages as well as to ensure their robustness in case of shocks. As market prices

contribute to interdependencies between markets and institutions (e.g. valuation, mark-to-

market type rules and other possible feed-back effects), regulators should ensure that price

formation processes are effective and robust.

Regulators are currently reviewing the existing parameters regarding various “circuit

breakers” in order to determine whether revisions might provide greater time for market

participants to reassess their strategies and resume trading in a fair and orderly fashion and

for algorithms to reset their parameters and help prevent extreme price movements. At the

same time, regulators are reviewing existing requirements relating to order and trade

cancellation policies, as well as other information sharing mechanisms that should also be in

place. Another example of measures which can contribute to the prevention of risk

transmission relates to settlement rules, including fines and close-out– requirements. Similar

rules across markets, accompanied by sizeable fines in case of settlement fails or other

measures such as close-outs, decrease arbitrage and the potential for disorderly settlement as

well as naked short selling.

legislative initiatives for the asset management industry (UCITS V, following the passage of UCITS IV

last summer) should try aligning remuneration frameworks between UCITS, AIFM and CRD; the

recent consultation from the European Commission will address the topic of remuneration. At the

domestic level, France has recently adopted a new industry code and there is an on-going consultation

in the UK.

47

Counterparty risk, interconnectedness and the role of CCPs

Central clearing is intended to reduce the overall amount of risks in the market and address

the issue of interconnectedness in the markets, by reducing multiple exposures and by

substituting a central counterparty in place of a counterparty member. CCPs strengthen a

market by holding its members to robust standards and requiring them to contribute to a

clearing fund which buffers against a member insolvency and default on its position. It also

encourages more rigorous risk discipline from market participants and limits the amount of

risk taking through the imposition of collateralisation practices and margin calls. When

central clearing is not possible (depending on the characteristics of the product), regulators

should encourage other risk management techniques, such as higher capital requirements (as

foreseen in the new Basel III framework), more rigorous counterparty analysis or oversight of

collateralisation practices at the firm level.

Given this increased CCP role envisioned by proposed reforms of OTC markets, regulators

and supervisors must ensure that they are subject to stringent business conduct rules and

harmonised organisational requirements to ensure their soundness. IOSCO has established a

Task Force on OTC Derivatives Regulation to develop consistent international standards

related to OTC derivatives regulation in the areas of clearing, trading, trade data collection

and reporting, and the oversight of certain market participants.62

In addition, IOSCO and the

Committee on Payment Systems and Settlements (CPSS) are currently engaged in reviewing

the regulatory standards that apply to payments, clearing and settlement arrangements,

including central counterparties.63

Liquidity risk

The last financial crisis has highlighted the systemic role of liquidity and the questions

around its availability in times of stress. In addition to the work taking place to better address

liquidity risk in the banking sector, securities regulators have engaged in a significant review

of liquidity regimes applying to securities firms. The Consultation Report published by

IOSCO in August 2010 highlights the lessons learned from the financial crisis, the necessary

changes to liquidity regimes and the need for increased supervision of liquidity risks.

A separate work stream for securities regulators focuses on liquidity risk for mutual funds

and collective investment schemes. The crises in the money market fund industry during the

financial crisis, and especially following the bankruptcy of Lehman Brothers in September

2008, underline the importance of the well functioning of the funds market for the financial

system and the possibility of runs on money market funds.64

Securities regulators have taken

steps to improve fund liquidity management (e.g. through suspensions of fund redemptions

62

IOSCO forms Task Force on OTC Derivatives Regulation, Press Release, 15 October 2010, available at

http://www.iosco.org/news/pdf/IOSCONEWS191.pdf.

63 IOSCO and CPSS consult on policy guidance for central counterparties and trade repositories in the

OTC derivatives market, Press Release, 12 May 2010, available at

http://www.iosco.org/news/pdf/IOSCONEWS182.pdf.

64 See also Money Market Funds Report, U.S. President‟s Working Group on Financial Markets, October

2010, available at http://www.treasury.gov/press-center/press-

releases/Documents/10.21%20PWG%20Report%20Final.pdf. The report acknowledges the positive

reforms implemented since the financial crisis but considers that more should be done to mitigate the

systemic risk associated with money market funds and reduce their susceptibility to runs. The report

discusses a number of policy options.

48

and the use of gates/side pockets) which can help prevent fire sales and runs on funds. While

the issues at stake and the potential regulatory solutions are fundamentally different from the

banking sector, the potential impact of poor fund management liquidity will require increased

scrutiny on the part of securities regulators (not only with respect to money market funds),

and possibly the elaboration of further international standards.

A.1.4 (a) How might measures against risk transmission have helped mitigate the

crisis?

One problem encountered by market participants during September and October 2008 was

tremendous uncertainty about which financial institutions were exposed to what risks. This

contributed to the rapid disappearance of liquidity. Institutions were forced into distressed

sales of assets causing price falls. The use of central counterparties, trade repositories and

exchange trading of derivatives would likely have helped reduce the severity of the crisis by

reducing counterparty exposures and uncertainty in the market. Data availability on OTC

trades would have helped market participants and regulators better identify the build-up of

risks in those markets and take actions.

While they would have been helpful in keeping money markets liquid and so staving off

losses of confidence during the crisis, rules about fund liquidity management might also have

helped prevent the crisis by making asset managers more aware of liquidity risk. The years

prior to the crisis were marked by a grave underestimation (and so underpricing) of liquidity

risks, and the accumulation of these risks contributed to the severity of the crisis. Awareness

of the importance of liquidity and its accurate pricing would thus have mitigated the risks

which developed in money markets before September 2008.

A.1.5 Emergency powers

In the event that there are market disruptions that could develop into a major shock,

regulators may have to take emergency action, for instance by temporarily suspending or

halting trading activities in certain securities, or by temporarily restricting certain market

activities, such as short selling. These are important and drastic measures that should only be

exercised in periods of high stress with the objective to prevent an adverse sequence of events

and amplification of market moves and to help market participants absorb information and

reassess their strategies. Those types of measures can also have unintended consequences,

for instance if market participants take positions in other related markets, where emergency

rules do not apply. On such occasions, coordination between regulators (nationally and

internationally) becomes crucial for emergency measures to be effective, which explains why

it is a key function of the systemic risk committees in many jurisdictions.

A.2 Raising awareness: Collaboration with other regulators and communication

tools

Securities regulators should regularly engage in dialogue with relevant supervisors and

regulators to ensure sufficient attention is being given to systemic risks arising from or

passing through securities markets. By communicating their systemic risk concerns,

securities regulators can raise awareness and help initiate actions from other regulators and

49

financial authorities, or, when needed, from legislators.65

A.2.1 Collaboration

Intra-jurisdictional communication and exchange of information among regulators about

systemic risk is essential to help prevent the emergence of gaps in oversight and identify

possible transfers of risks or cross-sectoral risks. In some jurisdictions, the creation of

systemic risk oversight bodies should facilitate communication and collaboration among

regulators. Securities regulators can reinforce their work by leveraging the work of other

regulators who share the common objective of promoting financial stability. Bringing issues

to the attention of other regulators can also lead to more effective combinations of prudential

and business conduct tools or the review of the respective perimeters of regulation. When

applicable, securities regulators can also call on self-regulatory organisations (SROs) to help

mitigate areas of risk that they directly regulate.

Because systemic risk in today‟s markets transcends borders, international collaboration

among regulators is also essential. Securities regulators should continue to collaborate

through IOSCO to improve transparency and disclosure in various international securities

markets, but they must also continue to be active participants in international supervisory

colleges. The perspective of regulators from different sectors can help not only to identify

risk, but also to better identify potential collateral consequences of proposed responses.

For example, the regulatory and supervisory framework for shadow banking currently being

discussed at the FSB requires collaboration among regulators to define more precisely the

potential sources of risks related to shadow banking across traditional perimeters of

regulation.66

The current view is that shadow banking is best defined along functional lines

rather than by entity. The key components of shadow banking are credit creation and

maturity and liquidity transformation occurring outside the banking system. Other important

aspects may include the interplay between maturity transformation and leverage, which can

substantially increase systemic risk, and the role of credit ratings, insurance and funding and

liquidity provision by banks in facilitating some of the activities occurring within shadow

banking. The possible outcomes will depend on the various forms of shadow banking

considered, the extent of their role in maturity transformation, their growth prospects (e.g.

impact of the new banking prudential framework), and the effectiveness of the various

prudential and non-prudential tools considered. Securities regulators provide important

perspectives on many of the forms of leverage credit and maturity transformation being

discussed.

Regulators should also share the results of their respective monitoring and research on risk,

especially when heightened cross-sectoral risks emerge. Domestic risk oversight boards will

provide a forum for such information sharing in many jurisdictions. Internationally, a forum

for such sharing of information might include IOSCO‟s proposed Standing Committee on

Risk and Research as well as the FSB‟s Standing Committee on Assessment of

65

In some cases, securities regulators‟ analysis may conflict with that of fellow agencies or they may

have to persuade them of the significance of financial developments related to securities markets.

66 “With regulatory requirements on the banking system tightening, we need to counter a likely

resurgence of shadow banking. Assessing the need to apply regulatory safeguards to shadow banking

will be a key priority of the FSB‟s reform agenda going forward.” FSB Letter to G-20 Leaders, 12

November 2010, available at http://www.financialstabilityboard.org/press/pr_101111b.pdf.

50

Vulnerabilities. Timely communication of research findings is essential to developing an

effective regulatory response, whether domestically or internationally.

A.2.2 Promoting Confidence through Communication about Risk

Securities regulators also have a unique role to play in promoting confidence in markets.

While mandates as to investor protection vary across jurisdictions, all securities regulators

have an interest in promoting confidence in capital markets. As discussed above, increased

disclosure and transparency gives investors more of the information that they need to allocate

capital away from risk or to require higher returns for riskier investments. Increased

transparency may also give regulators important information about risks related to specific

products, markets or participants. However, regulators would agree that even the most robust

disclosure and transparency regime, while helping to alleviate asset mispricing, can never

completely eliminate that mispricing and/or bubbles in securities markets that occur as part of

the cyclical nature of financial markets. However, there are likely to be instances where -

whether through monitoring, research, examinations or disclosures by individual registrants -

securities regulators may also be able to recognize broader risks that have not yet been

adequately disclosed to the market. Armed with such perspective, securities regulators

should take steps to ensure that these risks are made transparent to other regulators and,

where appropriate, to the market.

The objective of communication with other regulators is to learn and to raise awareness of

potential vulnerabilities, facilitate a thorough discussion of collateral consequences, and

develop coordinated policy responses. Communicating also creates an opportunity for

regulators to present their views and analyses to others and be challenged. There may be

times when regulators determine that it is appropriate to communicate concerns about

systemic risk directly to the public, but because communication about macro-economic trends

such as long-term pricing are traditionally within the purview of most central banks,

securities regulators should coordinate closely with the central bank and other regulators to

determine an appropriate communications strategy.

Through existing tools, securities regulators already play a role in communication with

markets, and those tools can be useful in addressing emerging risk. In addition to direct

communication with registrants to improve disclosure and enforcement actions relating to

disclosure, securities regulators can publish studies and risk outlooks and conduct industry

round-tables (perhaps via SROs, professional bodies and other industry groups) to raise

awareness of and/or seek information about emerging concerns. While securities regulators

should be careful about the content and form of their reports, some regulators may choose to

publish risk assessments on an ad-hoc or regular basis.67

This may assist the regulator in

developing its risk approach and contribute to strong market discipline.

67

Examples of such reports include FSA‟s Annual Risk Outlooks, AMF‟s Risks and Trends Mapping,

published annually; CESR‟s Trends, Risks and Vulnerabilities in Financial Markets, first published in

July 2010. Publishing efforts can be used to explain the priorities of regulators and support policy and

regulatory actions undertaken; they may also feed into the analysis provided by other financial stability

reports, such as the ones produced by central banks or international institutions (e.g. the IMF‟s semi-

annual Global Financial Stability Reports).

51

A.3 New responses to Financial Innovation, Leverage and Pro-cyclicality

The above tools are already available to securities regulators but can be used with the

objective of mitigating the build up of systemic risk. Regulators will also need to explore

other tools and actions. Securities regulators will want to address the development of

business models which rely on high levels of leverage and strong economic growth for their

viability. Usually these models surface towards the end of a boom cycle, and combine

financial innovation with easy credit. The dangers for the system arise from their

vulnerability to changes in the economic environment and the adverse consequences for

financial institutions and credit markets that result from high leverage.

A.3.1 Responding to financial innovation

Some of the causes of the financial crisis were associated with a range of financial

innovations, such as CDOs, CDSs, SIVs and others, prompting debate about their benefits

and complexity and how regulators should respond to those innovations. With respect to the

risks attached to financial innovations, there are many aspects to consider: innovations have

often the effect of transferring risks from one part of the system to the other, or increasing

leverage or interconnections between market participants; furthermore, it is difficult to

anticipate how some innovations may react to a shock, as well as how the ultimate allocation

of risks in the system might evolve. Innovations can also take various forms, such as new

products, new business models and entrants, new trading strategies and venues, and new

technologies. Due to the interconnections among markets and participants, the effects of

financial innovations can often resonate in various parts of the system and are not always a

direct result of the size or importance of the innovation itself (e.g. CDS markets).

Innovations and changes in the markets can also modify the relationships between different

market segments and, potentially, increase the potential for contagion (e.g. the interactions

between equities, derivatives and ETFs, as highlighted during the “flash crash” event).

Lastly, in most cases, financial innovation creates challenges for supervisors and regulators

who need to keep pace with the rapidly evolving marketplace.

A first range of response was to step up the requirements at the level of intermediaries

regarding the governance and risk management for new products, for instance through

product and risk committees. Regulators have also changed their approach to financial

innovations, with greater consideration of the risks. Examples of innovations under the

scrutiny of regulators include complex structured products, the growth of high frequency

trading or the growth of complex leveraged ETFs. The newly established systemic risk

bodies have also often been given the task to consider the impact of innovations on financial

stability.

A new framework for financial innovation will therefore need to include:

greater consideration of the risks attached to innovations at the level of financial

institutions and regulators;

close collaboration between supervisors and regulators to consider the various potential

impacts of innovations and transfers of risks and the evolving interconnections between

financial markets, institutions and products;

52

implications for the resources of regulators needed to maintain the appropriate level of

surveillance and control;

consideration of the international dimension of financial innovation in order to prevent

regulatory arbitrage.

A.3.2 Monitoring and tackling excessive leverage and concentration in the market

Securities regulators traditionally monitor firms and customers controlling or owning large

positions in particular securities or derivatives. The goal is to prevent market manipulation

but also to identify any risks relating to significant concentrations in the market (e.g. through

counterparty risks). In Hong Kong for example, following the Asian Financial Crisis in

2008, statutory position limits have been imposed on most of the derivatives products traded

on the exchange. In the United States, new legislation will allow the CFTC to impose

position limits across different markets, including the energy and agricultural markets, and

with respect to trading in certain OTC derivatives. In March 2009 the IOSCO Task Force on

Commodity Futures Markets called on all futures market regulators and other relevant

authorities to have access to information that permits them to identify concentrations of

positions and the overall composition of the market, comparable to the authority which the

CFTC already has. Reforms of the commodities markets are also expected in the European

Union in 2011.

The enhanced supervisory framework for hedge funds will also track the potential for a hedge

fund or group of funds to have systemic implications because of relative size or presence in a

market.68

In particular, IOSCO has developed a template to enable the collection and

exchange of consistent and comparable data amongst regulators and other competent

authorities for the purpose of facilitating international supervisory cooperation in identifying

possible systemic risk in this sector.69

The new supervisory framework for hedge funds will allow regulators to better monitor their

leverage (through borrowing or from positions held in derivatives), as well as some other

information such as the extent and nature of funding counterparty exposure. Regulators (or

systemic risk bodies) will then have the information necessary to take actions to impose

limits on leverage when the stability and integrity of financial markets may be weakened.

A.3.3 Pro-cyclicality and securities regulators’ tools

Traditionally, discussions about the pro-cyclicality of the financial system have focused on

the pro-cyclical effects of capital requirements. Other topics have since then been discussed,

including the impact of accounting standards, the role of credit ratings and the impact of

collaterisation practices. Regarding credit ratings, the “cliff effects” that can occur when

credit ratings are downgraded amplify pro-cyclicality and can cause systemic disruption.

From a securities regulation perspective, IOSCO‟s efforts have been directed to developing a

Code of Conduct containing measures to address concerns about the quality of credit ratings

68

IOSCO released Hedge Funds Oversight, Report of the Technical Committee of IOSCO containg new

regulatory requirements for hedge funds in September 2009, available at

http://www.iosco.org/news/pdf/IOSCONEWS166.pdf.

69 International regulators publish systemic risk data requirements for hedge funds, Press Release,

IOSCO, 25 February 2010, available at http://www.iosco.org/news/pdf/IOSCONEWS179.pdf.

53

and the conflicts of interest in agencies‟ business models.70

The Code of Conduct has since

been endorsed by the G-20 as the basis for regulation of credit rating agencies globally. In

addition, the FSB has made recommendations for regulators, central banks and private market

participants to reduce mechanistic reliance on credit ratings, which can give rise to “cliff

effects”.71

The full implementation of these measures would significantly improve the

quality of ratings and therefore help to address potential pro-cyclical effects. Regarding

accounting rules, standards with respect to impairment of assets are currently being reviewed

by the International Accounting Standards Board; this work could contribute to address some

of the pro-cyclical aspects of accounting rules while improving transparency and usefulness

of financial statements for users. Lastly, more work needs to take place with respect to

collateral practices and potential pro-cyclical effects.72

A.4 Reviews of the perimeter of securities regulation

Consistent with new IOSCO Principle 7, securities regulators should periodically review,

among other activities, the regulatory coverage of financing activities to ensure that none are

escaping appropriate regulation. Examples might include:

the rapid growth of new – and unregulated – financing activities;

the rapid growth of financing activities that have previously been lightly regulated, or

exempted from supervision by the securities regulator;

the conduct of activities by banks in the securities markets and that customers consider

are „safe as a bank” because they are being undertaken by a bank; and

the transfer of activities from the banking or insurance sectors to unregulated entities or

to entities within the securities sector, as prudential regulatory requirements increase.

This task will require securities regulators to:

regularly survey activity in financial and securities markets, so as to understand

developments and the potential for regulatory arbitrage, and identify opportunities for

cooperation and possibly changes;

set internal thresholds for intervening in new and expanding markets and activities; and

set regulatory goals for intervention, so that they can evaluate whether intervention has

been appropriate or needs to be modified.

70

Code of Conduct Fundamentals for Credit Rating Agencies, Technical Committee of IOSCO, May

2008, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD271.pdf.

71 Report on Principles for Reducing Reliance on CRA Ratings, Financial Stability Board, 27 October

2010, http://www.financialstabilityboard.org/publications/r_101027.pdf. The European Commission

has also launched a new consultation to re-examine certain aspects of the current regulatory

framework. In particular, the Commission notes that there are growing concerns that financial

institutions and institutional investors may be relying too much on external ratings and do not carry out

sufficient internal credit risk assessments, which may lead to volatile markets and instability of the

financial system, http://ec.europa.eu/internal_market/securities/agencies/index_en.htm.

72 See for instance, ,The role of margin requirements and haircuts in pro-cyclicality, Committee on the

Global Financial System, March 2010, available at http://www.bis.org/publs/cgfs36.pdf..

54

An important area for review will be banking-like financial activities, which securities

regulators may find within their perimeter, often called „shadow banking‟. Some examples of

shadow banking may include money market funds, securities lending against cash collateral

(where the cash is effectively callable and reinvested in longer-maturity assets), borrowing

through the overnight or short-term repo market and using the proceeds to invest into long-

term assets, ABCP conduits if issuing short-term liabilities (e.g. short-term CP), SIVs and

finance companies (if issuing short-term liabilities), and possibly some types of hedge funds,

such as credit hedge funds. The above list reflects some of the current legal structures and

entity types which were involved in the recent financial crisis (i.e. SIVs). As future structures

may change, the use of a functional definition of shadow banking will become increasingly

important

In circumstances where shadow banking activity is occurring, a decision should be made

jointly with the prudential regulator whether the securities regulator should consider, amongst

other possibilities:

whether to monitor and engage with other regulatory agencies and, if systemic risks are

deemed low, refrain from taking any action;

monitoring and regulating indirectly, via impacting on points of interaction between

shadow banking entities and areas where tighter regulations and controls already exist;

developing the capacity to apply regulation similar to that of prudential regulators;

seeking to modify certain characteristics of such products to make them less like

“banking” products;

strengthening disclosures and transparency, so that market participants have a better

understanding of the extent of maturity and liquidity transformation within products.; or

shifting the regulatory responsibility for those banking-like activities to the prudential

regulator.

The decision should be made according to the nature of the product and who is best suited

and able to provide the appropriate regulation, rather than on the lines of traditional

supervisory oversight. In this way, the risk of a major build-up of systemic risk will be

reduced.

Figure C sets out for illustration some examples of possible forms of systemic risk and the

indicators and actions available to securities regulators to address them.

55

Figure C: Examples Of Possible Systemic Risks And Actions Available

To Securities Regulators To Address Them

This figure suggests some types of systemic risks that might arise and the tools that securities

regulators might use to address them. The intent is to invite discussion on these issues.

Type of Systemic Risk Indicators Examples of tools that could be

used

1. Major market

imbalance

For example:

The market appears on

historical trends to be

substantially mispriced

Competitive pressure

driving margins to very

low levels

For example:

Market as a

whole is more

than

significantly

above a long

term average

Strong inflows

into an asset

class

Levels of

leverage are at

historical highs

Underwriting

standards

falling

Coordinate analysis and actions

with other regulators

Raise public awareness of

heightened risks in the market as

appropriate

Review prudential requirements

to ensure that they are consistent

with the level of risks in

particular markets/products

Emphasise disclosure and

suitability (where appropriate) in

supervision of financial advisors

2. Systemically important entity subject to securities regulators’ remit

For example:

A significant player with

a significant footprint

A global investment

bank

For example:

Analysis of

particular

entity/ entities

and discussions

with other

regulators

reveals a

concentration

of risky assets

on the balance

sheet of a fund

which has

borrowed

heavily from a

number of

SIFIs.

Improve cross border supervision

through e.g. multilateral

information exchange

arrangement and/ or supervisory

college

Require board of entity to report

to regulator on risk management

of counterparty exposures and

other risks, and share report with

prudential regulators

Consider making such reports

public to enhance disclosure

Analyse counterparty exposures,

with particular reference to retail

investors (including pension

funds)

Coordinate with prudential

regulator on exposures of

regulated entities

56

More regular and intense

inspection of entity

Analyse market segments in

which the entity is significant,

with particular regard to

substitutability

Increase loss absorbency capacity

through higher capital

requirements

3. Significant product in securities regulators’ remit with regulatory arbitrage

concerns or significant maturity mismatch

For example:

A significant product

develops promising

short redemption period

but underpinned by long

term assets, e.g. REITs

Marketing of complex

structured products /

leveraged ETFs to retail

investors

For example:

Data reveals

that SIFIs have

created SIVs

exposed to

significant

liquidity risks

and rapid

growth of

assets or new

structured

products

created from

innovative but

high-risk

financial

products

Surveys of

investor

sentiment and

motivations in

buying

particular

product

Raise or impose product

disclosure requirements with a

particular emphasis on risk

Revisit distribution channels to

retail investors

Analyze distribution agent

conduct with emphasis on

suitability, and take measures to

address inappropriate incentives

Address liquidity mismatch

through e.g. requiring listing or

increasing liquidity requirements

Alert fellow regulators and other

policy-makers about regulatory

gaps that should be addressed

57

B. IOSCO’s Role

IOSCO is the global standard setter for the securities markets. As standard setter it has a role

to play in providing guidance on measures to mitigate systemic risk. The standards it sets are

intended to be implemented by all member jurisdictions in their local laws and rules. IOSCO

has recently revised its Objectives and Principles to include two principles specifically

directed to monitoring and reducing systemic risk, as described in Chapter 1. This part of the

paper reflects the initial response of IOSCO on the tools that it might use or further develop

in mitigating systemic risks. As these tools develop, it will become clearer the extent to

which their use may mitigate systemic risk. As a conclusion to this part B, IOSCO‟s

initiatives in standard setting intended to help reduce systemic risk since the financial crisis is

discussed in Figure D.

B.1 Policy and Research

IOSCO has a role to play in providing guidance and developing policies and standards on

when and how the regulatory tools described in Part A of this chapter should be used. The

development of this guidance will encourage consistency and co-operation among securities

regulators in addressing systemic risk. For example, the Principles of Supervisory Co-

operation provide guidance on a range of areas, including the way regulators can co-operate

in identifying and assessing risks, including systemic risks.

The first commitment of IOSCO is to build a research capacity that will focus its initial

efforts on researching systemic risk. Some activities have already begun with a small

Research Unti being established at the General Secretariat. A new Standing Committee on

risk and research has been formed, composed of experts from securities regulators from the

most important markets. This Standing Committee will discuss and initiate research

activities. In addition IOSCO has decided to create an independent Research Department at

the General Secretariat which is intended to replace its existing Research Unit, scheduled to

be operative from the start of 2012.

The Research Department will prepare an Annual Global Securities Regulation Risk Outlook,

which aims to identify the most important systemic risks for securities regulation at a global

level. This will require elaborating the list of indicators in Appendix A, and then assessing

the extent of systemic risk across many jurisdictions

A second type of risk analysis is exploratory analysis that focuses on risks in specific

products, market segments or technologies. By publishing reports, IOSCO intends to initiate

discussions on major risks to the securities industry in order to raise the understanding

thereof. The Research Department will also establish a network of external experts,

composed of market practitioners, industry organizations and academia. This network can be

a source from which IOSCO can gather qualitative information on systemic risk arising in the

financial markets.

IOSCO considers that its particular contribution should be in analysing systemic risk from a

securities market perspective. Market regulators are uniquely placed to understand risks

emerging within or through the markets as a system, rather than as a collection of institutions.

As securities markets are globally interconnected, IOSCO has a special role to play in

analysing systemic risk that emerges through the interconnection of global markets.

However, in order to achieve this goal, significant expertise and resources will need to be

58

added to the Research Department. Furthermore, to be effective it will have to maintain its

independence to be credible and achieve its purpose.

B.2 Collaboration and Cooperation

Cooperation and collaboration on a global level is one of reasons for the existence of IOSCO.

IOSCO has taken the lead and has been instrumental in setting up the Multilateral

Memorandum of Understanding (MMOU) that deals with cooperation, collaboration and

information sharing for enforcement purposes between securities regulators. Using this

model, one option for IOSCO to help research and standard setting work related to systemic

risk is to encourage members to enter into bilateral Memoranda of Understanding (MoU) or

negotiate multilateral MoU‟s to address additional fields of cooperation, especially sharing

data and coordinating action on risks.

An additional step taken by IOSCO is to engage the SROs that are members of IOSCO

through the Self Regulatory Organization Consultative Committee (SROCC) on specific risk

topics. As these SROs are one step closer to markets than their supervisory authorities, it

would make sense to use their information, data and expertise to help the research function,

as well as to disseminate IOSCO messages or standards. IOSCO and its SROCC have already

started the engagement process where several discussions have already taken place. The

IOSCO Research Unit will be in consultation with the SROCC to identify possible areas of

collaboration in the future.

Another avenue for IOSCO to explore to mitigate risk and promote financial stability is

through regular stakeholder consultation. In these consultation meetings, IOSCO policy

makers discuss their work program with representatives of major industry organizations.

These meetings are held on a regular basis and provide an excellent opportunity to exchange

information about the build up of systemic risk. Their views can play an important role in

developing IOSCO‟s annual Global Securities Regulation Risk Outlook.

IOSCO is also considering organizing an intensive dialogue with relevant top level industry

groups to discuss important systemic risks in a manner similar to the Senior Supervisors

Group73

. This Group, from 2005 onwards, made a step by step improvement in trading and

clearing of the OTC derivatives market in an intensive dialogue with the largest banks.

On certain topics, IOSCO needs to work closely together with other global bodies, like the G-

20, FSB, BCBS, CPPS, IAIS, ESRB, IMF, World Bank and, where appropriate, reach out to

domestic bodies through IOSCO members. On more complex and broader risk areas with

cross-sectional implications, these global bodies can offer their expertise and experience in

coming up with solutions to mitigate such risks. The collaborative research will give IOSCO

a credible voice to work with these for a. The current standard-developing process of CPSS-

IOSCO is a good example that focuses on the complexities of global financial markets

infrastructures. The Basel Committee has been invited to contribute in this process and to

coordinate with the recent Basel III framework. Another important role here is the work of

the Joint Forum, made up of the Basel Committee, IAIS and IOSCO, that focuses especially

73

The senior supervisory group is composed of five countries and their respective regulatory agencies,

namely the French Banking Commission, the German Federal Financial Supervisory Authority, the

Swiss Federal Banking Commission, the U.K. Financial Services Authority, and, in the United States,

the Office of the Comptroller of the Currency, the Securities and Exchange Commission, and the

Federal Reserve.

59

on cross-sectoral issues.

A new area of activity that could be within the realm of IOSCO‟s global work could be

improvement to transparency and disclosure through setting standards for the collection of

data and standardizing documentation relevant to systemic risk. Further work on this topic

will have to be developed to clarify and assess the feasibility of such functions given the

costly nature of such an exercise.

B.3 Communication

By increasing awareness through developing IOSCO‟s outreach programs, website, training

and education programmes and other means, IOSCO can better prepare members, industry

participants, politicians and other global bodies to take steps to mitigate systemic risk

emanating from or passing through the securities markets. IOSCO‟s annual publications such

as the Global Securities Regulation Risk Outlook and Exploratory Analyses will also aid this

process. Another option would be to develop an information exchange website through the

IOSCO portal.

IOSCO can seek to directly influence the global debate on systemic risk by engaging in

dialogue with the G-20. IOSCO has been actively engaged with the G-20 and other global

bodies and standard setters throughout the crisis, and that level of engagement should

continue or increase. When IOSCO offers its expertise and shares its viewpoint on important

topics, dialogue occurs and work is more likely to be undertaken jointly to ensure securities

regulators are involved.

B.4 Stabilisation Tools

IOSCO can contribute indirectly to stabilisation through its international coordination and

outreach functions. Although not in a position to directly address issues such as pro-

cyclicality, it can provide guidance and best practices on how to address issues of systemic

risk at a national or global level.

Figure D: IOSCO’s Initiatives since the Financial Crisis

IOSCO has led (alone or jointly with other standard setters) a number of initiatives to address

significant failures identified with the financial crisis. These significant reforms, and other

work recently undertaken, illustrate how securities regulation can contribute to reduce

sources of risks in the system and help the monitoring of risks.

Regulating and monitoring market participants: IOSCO has published high level

principles for the regulation of hedge funds (including registration, and principles on

appropriate on-going regulatory requirements) (June 2009). These principles were later

followed by the release of a template for the global collection of hedge fund information

which will assist in assessing possible sources of systemic risk arising from the sector

(February 2010). IOSCO has also developed principles to guard better the integrity of the

rating process and ensure that credit rating agencies are subject to appropriate supervision

(March 2009). Additionally, IOSCO has reviewed due diligence for investors investing

in structured products (July 2009) as well as internal controls in place at intermediaries

associated with price verification of structured products (August 2010); this report also

discussed regulatory approaches to liquidity risk management; further work on liquidity

60

risk is now taking place in Standing Committee 5 (Asset Management) of IOSCO.

Promoting transparency and soundness in the markets: IOSCO supports the reforms of

the OTC markets. Given the central role given to central clearing counterparties and

trade repositories, the work currently conducted by CPSS-IOSCO will ensure that the

level of standards applying to those entities will be sufficiently robust. The FSB has also

asked IOSCO to lead the reflections on exchange trading of OTC derivatives, reporting

and aggregation requirements. IOSCO's TFUMP report has also recognised the gaps in

the regulation and supervision of the securitisation and CDS markets, and recommends

(among other things) enhanced investor transparency, better alignment of interests

between originators/sponsors of securitised products and investors, more accurate and

timely market data, and improved risk management. In addition, IOSCO has set up a

Task Force on commodities markets.

Monitoring trading practices: IOSCO has established a Task Force on Short Selling and

issued high level principles for the effective regulation of short selling (June 2009),

including the need to establish appropriate controls in order to reduce or minimise the

potential risks to the orderly and efficient functioning and stability of markets.

Limiting risks from innovations and other changes in the market: IOSCO has published

Principles on Direct Electronic Access to Markets which are based on the recognition that

markets, intermediaries and regulators must each play a role in addressing the potential

risks posed by DEA (August 2010). IOSCO has published a consultation document

relating to the growth and impact of dark pools (October 2010) and is currently working

on potential risks relating to the development of high-frequency trading (HFT) as well as

the growth of exchange-traded funds (ETFs).

Improving cooperation between regulators: IOSCO has worked to enhance cross-border

supervisory cooperation and information sharing among regulators through discussions,

memoranda of understanding, supervisory colleges and networks of regulators (May

2010).

Preventing regulatory loopholes and favouring cross-sectoral cooperation: IOSCO was

part of the Joint Forum‟s Task Force on Differentiated Nature and Scope of Regulation

(January 2010) and contributed, again with the two other standard setters, to the review of

the treatment of Special Purpose Entities

61

Chapter 5 Conclusion

Securities regulators have a key role to play in identifying and mitigating systemic risk.

Incorporating a greater emphasis on reducing systemic risk into their everyday tasks and

processes will have significant implications for the way securities regulators perceive their

role. It will also impact the way they define their responsibilities, communicate with market

participants and cooperate with other regulatory and supervisory authorities sharing systemic

risk responsibilities. Their market knowledge gives securities regulators a unique and useful

perspective in identifying, analyzing, monitoring and mitigating systemic risk building up in

the financial system.

Securities regulators recognize that they share responsibility for dealing with systemic risk

with central banks and prudential regulators, which have traditionally been the focal point for

stability of the overall financial system. Consequently, IOSCO and securities regulators look

to work with central banks and prudential regulators in developing their approach with

respect to systemic risk and contributing to financial stability. At the global level,

cooperation between regulators and supervisors through bodies such as the FSB, the Basel

Committee and IOSCO is essential to promote the sharing of information and the

combination of expertise and coordination of actions. In addition, the global and

interconnected nature of modern financial markets makes it even more important that

securities regulators, along with IOSCO, play a key role in addressing systemic risk.

To better define the role and contribution of securities regulators in this respect, IOSCO has

established two new principles of securities regulation: that securities regulators have or

contribute to a process to monitor, mitigate and manage systemic risk appropriate to their

mandate; and that securities regulators have or contribute to a process to regularly review the

perimeter of regulation. This Discussion Paper builds on those principles and initiates a

process of developing a methodology for the identification, analysis, monitoring and

mitigation of systemic risk as well as the promotion of financial system stability. IOSCO has

established a research function to focus on emerging sources of systemic risk and produce a

Global Securities Regulation Risk Outlook, building on and complementing the work of

bodies such as the IMF.

IOSCO will continue to discuss and develop its views on key risk measurements and ways to

mitigate systemic risk, building on this analysis. This paper highlights the following

preliminary findings:

1. Disclosure and transparency are critical to identifying the development of systemic

risk and to arming regulators with the information needed to take action to address it.

Transparency in markets and products is crucial to understanding and mitigating

systemic risk, in addition to allowing market participants to better price risk.

Securities regulators have a particular responsibility and interest in promoting

transparency at the market level as well as adequate disclosure at the product and

market participant level.

2. Robust regulatory supervision of business conduct is essential to managing conflicts

of interest and the build-up of undesirable incentive structures within the financial

system. Without it, incentives can quickly become distorted with drastic

consequences such as increased leverage and risk in the system. With it, investor

confidence is likely to provide greater stability to the market.

62

3. Financial innovation and its implications for financial stability should be a focus for

securities regulators. Innovation should be encouraged and facilitated where it has the

potential to improve the efficiency of the markets or to bring useful products and new

participants to the market. Innovation which involves opacity or improper risk

management should be carefully monitored.

4. Given the central role of markets in the overall financial system and their capability to

generate and/or transmit risks, securities regulators should work with other

supervisors to improve the overall understanding of the economics of the securities

markets, their vulnerabilities and the interconnections with the broader financial

sector and the real economy. Sharing of market information and knowledge, will be

essential to deliver a truly efficient regulatory response to systemic risk.

5. It is important for securities regulators to develop key risk measurements relevant to

systemic risk arising within securities markets, and improve their understanding and

application of tangible steps to mitigate identified systemic risk.

The above findings form the foundation of robust and effective systemic risk frameworks for

securities regulators. The development of processes to address systemic risk is an evolving

field for securities regulators which will require ongoing research. It will also be important

for IOSCO to continue to engage its members in the development of systemic risk

frameworks.

63

Appendix A: Possible Indicators Relevant To Systemic Risk

Micro level indicators

Securities regulators should monitor micro-level developments to gauge problems as arising

from knowledge gaps, regulatory gaps, and the extent of transparency. Indicators for these

problems include:

rapid developments in market segments;

growth of particular participants;

concentrations of positions in certain market segments;

opacity of primary and secondary markets;

inadequate or overly-complex disclosure;

heavy reliance on risk modelling or credit ratings, especially for risk management of

new products;

rapid advances in technology; and

changes in market structure.

Potential indicators related to specific sources of Systemic Risk in the securities markets

Regulators may also want to monitor more specific micro-level indicators related directly to

the identified sources of systemic risk. The following is a list of potential indicators which

can help securities regulators identify systemic risks. Most often, it is a combination of these

indicators which can reflect the potential for systemic risk.

a) Size

Individual market size (relative, absolute and the rate of growth):

i. debt markets

ii. equity markets

iii. derivatives markets

iv. Others.

Products (relative, absolute and the rate of growth)

i. Investor base

ii. Funding base/dependency

64

Market participants and key gatekeepers (relative, absolute and the rate of

growth)

i. Issuers

ii. Intermediaries (especially those considered systemically important or

too-big-to-fail)

iii. Institutional investors

iv. CRAs, auditors and etc.

Market activities

i. Short selling (volume, positions outstanding, especially net short

positions

ii. Securities lending (amount on loan)

iii. High-frequency or algorithmic trading (share of turnover, share of

orders)

b) Interconnectedness

Counterparty exposure information collected from participants

Levels of cross border exposures and dependencies

Measures of correlation between markets, products and institutions

Degrees of leverage on balance sheets

Ownership of assets (a measure of exposure to price falls)

Liquidity (different measurements)

i. Institution based

ii. Market based (i.e. spreads)

CCP data

Trade repositories

c) Substitutability and Concentration

Participant market shares in various segments

Scale of Exposure to individual assets, markets and institutions

65

Data about the size of positions held (e.g. trader commitment data collected by

the CFTC)

Measures of market concentration and competition such as the Herfindhal-

Hirschman Index (HHI)74

Qualitative assessments of the availability of alternatives/substitutes

d) Lack of Transparency and Knowledge Gaps

Review of potential knowledge gap regarding market activity

i. Short selling

ii. Alternative investment funds

iii. Debt and derivatives markets

iv. OTC markets in general

Proportion of activity on non-transparent markets

i. Dark pools/Internalization/Dark liquidity in general

ii. Non-exchange traded derivatives transactions

Proportion of exempt market transactions

Continuous disclosure review outcomes

Measures of investor education/literacy

Level of failed settlements

Differences in settlement regimes between national jurisdictions

e) Leverage

Institutions balance sheets

Margin lending levels and haircuts (e.g. for repos)

Leverage levels of funds

Trends in product leverage

74

The Herfindhal- Hirschman Index (HHI) is a commonly accepted measure of market concentration

http://www.justice.gov/atr/public/testimony/hhi.htm.

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Size of derivatives market(s)

f) Behavioural Issues

Trends in remuneration practices

Trends in selling practices

i. Surveys/Outcomes from mystery shopper tests

ii. Regulators‟ compliance data

Leveraged capital gains investing

Herding/flow of funds

Changes in investment strategy

g) Regulatory Gaps

Proportion of unregulated transactions

Existence of under-regulated areas of markets (e.g. shadow banking)

Evidence of regulatory or supervisory arbitrage

Shared jurisdiction.

Indicators of risk transmission

network analysis of counterparty exposures

measures of changes in market liquidity and funding liquidity

monitoring correlation between firms, markets, and asset classes

monitoring situations that appear to be tightly coupled

monitoring surveys of investor confidence

Macro level indicators

Securities regulators may also find it useful to maintain an awareness of macro-level

indicators of conditions relevant to the securities markets, including how they could impact

the behaviour of market participants and investors. Macro factors can also have a link with

micro-level business models, which, for example, require uninterrupted access to short-term

funding and, as a result, are highly vulnerable „when the music stops‟. The indicators that

securities regulators may want to monitor include, but are not limited to:

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Macro economic data (e.g. interest rates, inflation, economic growth rates, flow of

funds, changes in the money supply and credit growth, asset purchase programs by

central banks, interbank lending);

Fiscal debt sustainability – sovereign debt and overall indebtedness of market

participants, issuers or individuals in aggregate;

Indicators of deviations from long-term value of assets (e.g. Tobin´s Q, Shiller´s

CAPE75

);

Asset prices and spreads (e.g. credit spreads, equity markets, commodity markets)

Movement of international capital flows;

The geopolitical environment; and

Systemic risk indicators developed by other organizations (e.g. IMF, ECB, BIS, and

FSB).

75

Developed by Yale Professor Robert Shiller, Cyclically Adjusted Price to Earnings ratio (CAPE).

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Appendix B – List of Task Force Members

Co-Chairs

Autorité des marchés financiers, Quebec Jean St-Gelais

President and

Chief Executive Officer

Ontario Securities Commission Howard I. Wetston

Chairman

Drafting Group

Alberta Securities Commission Steven Weimer

Australian Securities and Investments Commission Steven Bardy

Alex Erskine

Autorité des marchés financiers, France Julie Ansidéi

Autorité des marchés financiers, Quebec Serge Boisvert

Jean Daigle

Jean Lorrain

Louis Morisset

Ontario Securities Commission Paul Redman

International Organization of Securities Commissions Werner Bijkerk

International Organization of Securities Commissions Samad Uddin

Members

Australian Securities and Investments Commission

Comissão de Valores Mobiliários, Brazil José Alexandre

Cavalcanti Vasco

Comissão de Valores Mobiliários, Brazil Mr. Leonardo José

Mattos Sultani

China Securities Regulatory Commission Yifeng HUA

Yang Zhiying

Chen Mo

Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) Dr. Stefan L. Pankoke

Philipp Sudeck

Jana Klein

Securities and Futures Commission, Hong Kong Martin Wheatley

Beatrice HY LUK

Securities and Exchange Board of India (SEBI) Amarjeet Singh

S. Ravindran

Israel Securities Authority Hadas MAGEN

Dr. Gitit Gur-Gershgorn

Yael Almog

Commissione Nazionale per le Società e la Borsa, Italy Nicoletta Giusto

Financial Services Agency, Japan Yuichiro Enomoto

Masamichi Kono

Comisión Nacional Bancaria y de Valores Mexico Angelica Gonzalez-Saravia

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Netherlands Authority for the Financial Markets Piebe Teeboom

Niels de Kraker

Securities and Exchange Commission, Nigeria Bibian Okereafor

Adamu Sambo

Ontario Securities Commission Tula Alexopoulos

Howard Wetston

Paul Redman

Comissão do Mercado de Valores Mobiliários, Portugal Carlos Tavares

Margarida Matos Rosa

Autorité des marchés financiers, Quebec Mario Albert

Louis Morisset

Jean Lorrain

Jean Daigle

Serge Boisvert

Comisión Nacional del Mercado de Valores, Spain Santiago Yraola

Jose Manuel Portero

Óscar Arce

Swiss Financial Market Supervisory Authority Daniel Zuberbühler

Marco Franchetti

Financial Services Authority, United Kingdom Verena Ross

Richard Brazenor

Priyanka Malhotra

Ana Duarte

Commodity Futures Trading Commission, United States Jacqueline Hamra Mesa

Warren Gorlick

Securities and Exchange Commission, United States Ethiopis Tafara

Sherman Boone

Robert Fisher

Erin D. McCartney